Chapter 9
The Banking Firm and
the Management of
Financial Institutions
Dr. Reyadh Faras

Commercial banks are the most important
financial intermediaries in the economy, so it is
important to understand how they operate, and
understand bank management.
THE BANK BALANCE SHEET

To understand how a bank operates, we first
examine a commercial bank's balance sheet,
where:
Total Assets = Total Liabilities + Capital
Dr. Reyadh Faras
‫ميزانية البنك التجاري (‪)Balance Sheet‬‬
‫األصول‬
‫اإللتزامات‬
‫احتياطيات‬
‫(نقدية‪ ،‬ودائع لدى البنك المركزي)‬
‫ودائع‬
‫(جارية‪ ،‬ادخارية‪ ،‬ثابتة)‬
‫أدوات دين حكومية‬
‫(أذونات خزانة‪ ،‬سندات)‬
‫اقتراض‬
‫(من البنك المركزي‪ ،‬بنوك أخرى‪،‬‬
‫شركات قابضة‪ ،‬بنوك أجنبية)‬
‫قروض (استهالكية‪ ،‬عقارية‪ ،‬تجارية‪،‬‬
‫بنوك أخرى)‬
‫حقوق المساهمين‬
‫(رأس المال‪ ،‬أرباح محتفظ بها)‬
‫أصول ثابتة‬
‫(مباني‪ ،‬أثاث‪ ،‬أنظمة إلكترونية)‬
‫‪Dr. Reyadh Faras‬‬
The Bank Balance Sheet
Dr. Reyadh Faras
BANK LIABILITIES (Sources of Funds, Sources of costs)
1. Checkable Deposits (11%)
Are bank accounts that allow owner of the account to
write checks to third parties. They include:
a. Demand deposits (non-interest-bearing checking)
b. Negotiable Order of Withdrawal (NOW) accounts
(interest-bearing checking)
c. Money market deposit accounts (MMDAs) - money
market mutual funds.
Dr. Reyadh Faras

Checkable deposits are payable on demand, you
can write a check for any amount, including your
entire balance.

Checkable deposits are lowest cost source of funds
for a bank, sometimes zero (demand deposits).

Because people like the liquidity of checking
accounts, they are willing to forego interest for
convenience of checks.
Dr. Reyadh Faras
2. Nontransaction Deposits (52%)
Account owner is not allowed to write checks, but
receives interest rates higher than checkable
deposits.
a. Savings accounts:
Funds can be added or withdrawn from the account.
b. Time Deposit Accounts:
 Fixed maturity from several months to 10 years.
 Higher interest rates than saving accounts.
 Has penalties for early withdrawal.
 Less liquid.
 More costly source of funds for the bank.
Dr. Reyadh Faras
Interest Rates on KD Time Deposits (%)
Amount
1
Month
2
Months
3
Months
4
Months
6
Months
9
Months
12
Months
1,500 – 9,999
5.0000
5.0625
5.1875
5.1875
5.3125
5.3750
5.4375
10,000 –
50,000
5.1250
5.1875
5.3125
5.3125
5.4375
5.5000
5.5625
50,001 –
250,000
5.2500
5.3125
5.4375
5.4375
5.5625
5.6250
5.6875
250,001 –
999,999
5.375
5.4375
5.5625
5.5625
5.6875
5.7500
5.8125
Longer Time Deposits
2 Years
3 Years
4 Years
5 Years
5.9375
6.2500
6.5000
6.7500
Dr. Reyadh Faras
3. Borrowings (29%)
a. From other banks (interbank Market)
b. From the central bank (discount Window)
c. From parent companies (bank holding companies)
d. From corporations (repurchase agreements)
e. From foreign banks (Eurodollar deposits)
f. Issue debt instruments (Commercial Papers, Bonds)
Dr. Reyadh Faras
4. Bank capital (Net Worth) (8%)

Net worth is the difference between total assets
and liabilities.

Consists of stocks and retained earnings.

Bank capital is a cushion against a drop in the
value of assets, to protect against bankruptcy
(insolvency).
Dr. Reyadh Faras
BANK ASSETS (Uses of Funds, Sources of income):
Banks use their deposits to acquire income-earning
assets, to make profits, by earning more interest on
assets than they pay out on liabilities.
1. Reserves (1%):
 Consists of deposits kept on account at the central
bank plus cash held at the bank.
 Some reserves are required by the central bank
and others are voluntary.
Dr. Reyadh Faras

Required Reserves: banks are required to hold a
percentage of certain deposits in an account at the
central bank.

Excess reserves: in addition to required reserves,
banks hold extra reserves for increased liquidity
(to meet demand for cash withdrawals and check
clearing).
Dr. Reyadh Faras
The Required Reserve Ratio Over Time (%)
1968
1978
1988
1998
United Kingdom
20.5
15.9
5.0
3.1
Turkey
58.3
62.7
30.8
18.0
Germany
19.0
19.3
17.2
11.9
United States
12.3
10.1
8.5
10.3
Dr. Reyadh Faras
The Required Reserve Ratio Around the World
Country
RRR
(%)
Australia & Canada
None
Euro Zone
2.0
Since 1999
4.0
Effective 1/4/2011,
up from 2.5 in 1/2011
6.0
Since December 2010
Russia
Bangladesh
Note
Since February 2011
Turkey
8.0
China
21.5
For major Chinese banks since 14/6/2011,
it was 15.5%. Small/Medium banks: 18.5%
Surinam
25.0
Down from 27%, effective from 1/1/2007
Lebanon
30.0
Dr. Reyadh Faras
Required and Excess Reserves in the US: 2007- 2009
Dr. Reyadh Faras
2. Cash Items in Process of Collection
Funds from checks written on other banks but are
not yet collected (received) from the other bank.
3. Deposits at Other Banks
Many (small) banks hold deposits at other (larger)
banks to use them in getting a number of services
such as: check collection, foreign exchange
transactions, and buying securities.
Dr. Reyadh Faras
4. Securities (22%):

An important source of income to banks.

Made up entirely of government debt instruments
because commercial banks are not allowed to own
stocks.

Short term securities are highly liquid, thus are
called secondary reserves.
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5. Loans (66%):
Most bank profits come from Loans.
A loan is a liability for the borrower but an asset for
the bank because it generates income.
Loan Types:
a. Commercial loans to businesses
b. Real estate loans (mortgages, home improvement
loans)
c. Consumer loans (Cars, furniture)
d. Interbank loans (overnight loans to other banks
through the interbank market)
Dr. Reyadh Faras



Loans are less liquid than other assets because
they are tied up for the length of the loan.
Loans are also more risky, have higher default
risk than securities.
Because loans are more risky and less liquid, they
earn more interest for banks.
6. Other Assets (7%):
 Buildings, office equipment, computer systems,
etc.
Dr. Reyadh Faras
Summarized Balance Sheet
Assets
Liabilities + Capital
Reserves
Deposits
Securities
Borrowings
Loans
Capital
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BASIC OPERATION OF A BANK
Asset Transformation:
 Banks make profits by selling liabilities with one
set of characteristics (liquidity, risk, and return)
and buying assets with different set of
characteristics.
Example:
A savings deposit (liability) can be used by the
bank to make a loan (asset).
 The bank borrows short-term and lends longterm.

Dr. Reyadh Faras
Characteristics of Assets and Liabilities
Assets
Liquidity
Risk
Return
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Liabilities
Weighted Averages Interest Rates on
Loans and Deposits in Kuwait (%)
Year
2004 2005 2006 2007 2008 2009 2010 Average
W.A. Loan
Rate
5.637 7.497 8.579 8.539 7.578 5.885 5.14 6.7855
W.A. Deposit
2.655 3.469 4.925 5.451 4.806 2.895 2.318 3.8675
Rate
Interest Rate
2.982 4.028 3.654 3.088 2.772 2.99 2.822 2.918
Spread
Dr. Reyadh Faras

The process of asset transformation and providing
services (e.g. check clearing, credit analysis) is
similar to the production process by firms.

If the bank produces at low cost and earns higher
return on its assets, then it makes profit, vice
versa.

A tool used in analyzing bank operation is the
T-account: a simplified balance sheet that lists
only changes occurring in balance sheet items
from a transaction.
Dr. Reyadh Faras
Example 1

1. A person opens a checking account at “First
National Bank )FNB(” with $100 in cash. This
shows up as a liability on the bank balance sheet.

If the bank keeps the $100 as cash, this raises the
bank assets (vault cash).
First National Bank
Assets
Liabilities
Dr. Reyadh Faras

Since the cash is part of the bank’s reserves, we
can rewrite the T-account as follows:
First National Bank
Assets
Liabilities
Result: opening a checking account with cash
increases the bank’s reserves equal to the increase
in checkable deposits.
Dr. Reyadh Faras
Example 2
2. If a person opens a checking account with a $100
check written on her account at another bank
“Second National Bank )SNB(.”
 FNB is owed $100 by SNB. This asset for FNB
appears in its T-account as cash items in process
of collection.
 FNB deposits the check in its account at the
central bank who transfers $100 of reserves from
SNB to FNB.
Dr. Reyadh Faras
First National Bank
Assets
Liabilities
The final balance sheet positions of the two banks
are as follows:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras
Second National Bank
Assets
Liabilities
Result:
when opening a checking account with a check, the
bank receiving the deposit gains reserves equal to the
amount of the check, while the bank on which the
check is written loses reserves by the same amount.
Dr. Reyadh Faras
Making profit



If FNB receives a $100 checkable deposit.
If the required reserve ratio is 10%.
The required reserves are $_____, and the excess reserves
are $_____. The T-account becomes:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras

If the FNB decides not to hold excess reserves, it
makes a loan of $____ (Why not $100?), the Taccount becomes:
First National Bank
Assets
Liabilities
If the bank charges 10% on loans, managing each
account costs $3, paying 5% interest on each account.
What’s the bank's profit from the two transactions?
Profit =
Dr. Reyadh Faras
Gulf Bank Income Statement (2007, million KDs)
A. Interest income (from loans and interbank deposits)
315.3
B. Interest expenses (on deposits and borrowings)
208.7
Net Interest income (A-B)
105.5
Fees and commissions
23.4
Net gains from dealing in foreign currencies
14.9
Dividend income
0.77
Income from disposal of investments available for sale
48.7
Operating Income
195.6
Staff expenses
22.1
Occupancy costs
1.8
Depreciation
2.2
Operating expenses
36.4
Operating Profit
135.3
Dr. Reyadh Faras
Continue…Income Statement
Operating Profit
135.329
Contribution to Kuwait Fund for the Advancement of Sciences
1.354
Directors’ emoluments
0.108
National Labor Support Tax
3.347
Zakat
.083
Net Profit
130.437
Earnings per Share (Fils)
122.142
Dr. Reyadh Faras
GENERAL PRINCIPLES OF BANK MANAGEMENT
1. Liquidity Management:
Maintaining enough liquid assets to meet obligations to
depositors and to the central bank.
2. Asset Management:
Managing assets to achieve diversification and
minimize rate of default and interest rate risk.
3. Liability Management:
Acquire funds at the lowest possible cost.
4. Capital Adequacy Management:
Maintaining the appropriate capital (net worth) to meet
central bank regulations and prevent bank failure.
Dr. Reyadh Faras
FIRST: LIQUIDITY MANAGEMENT
Management of bank reserves. Two concerns:
1) excess reserves and 2) insufficient reserves.
Example (1): Bank holds excess reserves
Assume the bank's initial balance sheet is as follows:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras


If required reserve ratio is 10%, the required
reserves are: _____. But since the bank's total
reserves are ______, the excess reserves are _____.
If depositors withdraw $10 million, the bank's
balance sheet becomes:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras
The bank lost $_____of deposits and
$_____of reserves. The required reserves declined
from $______ to $______ (Why?).
 Excess reserved declined from $______ to $______
(why?)


Result:
If a bank has excess reserves, a decline in its
deposits does not necessitate (leads to) changes in
other parts of its balance sheet (Except:___ & ___)
Dr. Reyadh Faras
Example (2): Bank holds no excess reserves
Assume the bank's initial balance sheet is as follows:
First National Bank
Assets
Liabilities
If depositors withdraw $10 million, the bank's balance sheet
becomes:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras
The bank lost $____of deposits and $____of reserves.
Total reserves declined from $______ to $_______.
Required reserves should be $______, but the bank
has $_____ reserves (is there a problem?)
What do we mean by a problem?
1.
2.
To get funds to meet reserve requirements, the bank
has four options:
Dr. Reyadh Faras
1. Borrow from other banks
(from the __________market), or from corporations.
In this case the balance sheet becomes:
First National Bank
Assets
Liabilities
The cost of this option is the amount of interest
paid on the loans.
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2. Sell securities
Sell securities and deposit the revenues with the
central bank, the balance sheet becomes:
First National Bank
Assets
Liabilities
Selling securities has brokerage costs, they are low
for government securities because they are very
liquid, but may be high for other securities.
Dr. Reyadh Faras
3. Borrow from the central bank
Borrow from the C.B., the balance sheet is:
First National Bank
Assets
Liabilities
Two costs:
A. The amount of interest paid on the loan.
B. Indirect Costs: 1) The C.B. discourages too much
borrowing, 2) the C.B. carefully examines the bank,
and 3) the C.B. may close the discount window.
Dr. Reyadh Faras
4. Reducing Loans
The bank can reduce loans in two ways:
1) don't renew short term loans and 2) sell loans to
other banks and deposit the revenues with the
C.B. The balance sheet become:
First National Bank
Assets
Liabilities
Dr. Reyadh Faras
This is the costliest way because:
1) Not renewing loans discourages future business
with borrowers.
2) Selling loans may require banks to sell them at
lower value to encourage other banks to buy them
(why?).
3) The bank will forego potential interest on loans.
General Result:
1) Excess reserves are insurance against the costs
associated with deposit outflows.
2) The higher the costs to provide required reserves,
the more excess reserves banks will want to hold.
Dr. Reyadh Faras
SECOND: ASSET MANAGEMENT
Banks manage their assets to maximize profits by:
1. Assess creditworthiness of potential borrowers to
avoid costly defaults.
(Banks usually conservative, default rate is low)
2. Buying securities with high returns and low risks.
3. Diversify assets:
 Securities: Short term (T-bills) and long term
(Government bonds)
 Loan portfolio (commercial, industrial, consumer,
real estate).
Dr. Reyadh Faras
Kuwait’s Banks: Assets (Million KDs)
Sight
Time
Claims Claims
Local
Deposits Deposits CBK
on
on
Foreign Interbank
Year Cash with
With Bonds Gov’t Private Assets Deposits Total
CBK
CBK
Sector
2004 75.3
174.9
126.0
2005 105.9
111.7
2006 148.6
-
2750.0 10885.8 3192.0
1404.8
19144.2
440.4
124.0 2463.1 12936.7 3794.1
1014.0
21611.6
50.2
926.2
356.0 2165.1 16148.2 5245.8
1290.8
26990.0
2007 115.2
483.6
813.0
590.6 1911.8 21820.0 7632.6
1389.8
35553.3
2008 161.4
371.3
97.3
374.5 1996.4 25450.3 8796.0
671.9
39241.0
2009 168.1
224.8
872.6
1017
1921.7 27018.7 7354.1
854.7
40320.7
2010 163.7
78.1
1373.7
1344
1910.3 27526.8 7272.4
906.3
41374.8
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Maturity and the Volatility of Bond Returns
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4. Manage assets to ensure liquidity by holding
sufficient liquid assets in case of large deposit
outflows.

For example, T-Bills are so safe and liquid that
they are considered "secondary reserves."

The bank has to balance liquidity (cash) against
increased earnings from less liquid assets (loans).
Dr. Reyadh Faras
Capital Adequacy Management
Banks choose the amount of capital they hold for
three reasons:
1. It Helps Prevent Bank Failure:
Bank failure occurs when a bank cannot satisfy its
obligations to pay its depositors and creditors and so
goes out of business.
Example
Consider two banks, one with low capital to assets
ratio and the other high ratio.
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High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
Dr. Reyadh Faras
If the two banks lose $ 5 million of their loans, their
assets and capital will decline too by the same amount.
The new balance sheets become as follows:
High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
Dr. Reyadh Faras

The high capital bank is in a good situation
because its net worth (capital) is positive ($5 m.).

The low capital bank is in a bad situation because
its net worth is negative (-$1 m.).

The value of its assets is less than its liabilities,
therefore it is insolvent (bankrupt):
It does not have enough assets to pay off holders of
its liabilities (depositors, creditors).
Dr. Reyadh Faras
2. It Affects Returns to Equity Holders
Bank owners need measures indicating if the bank is
being managed well or not.
Return on Assets (ROA):
ROA = net profit after taxes / assets
The ROA shows how efficiently a bank is being run by
indicating how much profits are generated on average
by each dollar of assets.
Return on Equity (ROE):
ROE = net profit after taxes / equity capital
The ROE shows how much the bank earns on equity
investment.
Dr. Reyadh Faras
Equity Multiplier (EM):
EM = assets / equity capital
It is the amount of assets per dollar of equity capital.
It shows the direct relationship between ROA and
ROE:
ROE = ROA X EM
The formula shows what happens to the return on
equity when a bank holds a smaller amount of equity
capital for a given amount of assets.
Dr. Reyadh Faras
Example
The high capital bank: EM = $___ m. / $___ m.=
The low capital bank: EM = $___ m. / $___ m.=
If ROA is 1%, then:
ROE for the high capital bank = ___% X ___ = ___%
ROE for the low capital bank = ___% X ___ = ___%
Dr. Reyadh Faras
Equity holders of the low capital bank are happier
because they have a return more than twice higher.
Thus, bank owners don't like holding a lot of capital
( because it reduces ROE).
Result:
Given the ROA, the lower the bank capital, the
higher the ROE. This show that there is a trade-off
between safety and returns.
3. Bank Capital Requirements
Banks hold capital because they are required by
law to do so.
Dr. Reyadh Faras
Managing Interest Rate Risk
High volatility in interest rates makes banks exposed
to interest- rate risk:
The possible reduction in returns associated with
changes in interest rates.
First National Bank
Assets
Liabilities
Rate-sensitive Assets
Rate-sensitive Liabilities
Fixed -rate Assets
Fixed-rate Liabilities
Dr. Reyadh Faras
Example
If interest rate rises from 10% to 15% ( Δ = ___%)
Δ Profit = Δ income – Δ cost
Δ income = Δ interest X rate sensitive assets
= ___% X $ ____ million = $ ___ million
Δ cost = Δ interest X rate sensitive liabilities
= __% X $ ___ million = $ ___ million
Δ Profit =
However, if interest rate falls by 5%, profit ____ by
$___million.
Dr. Reyadh Faras
Gap Analysis
- It is a measurement of the Sensitivity of bank profits
to changes in interest rates.
- The gap can be calculated by subtracting the
amount of rate sensitive liabilities from the amount
of rate sensitive assets.
- Gap = RSA – RSL = ____ – ____ = $ ____ million
Δ profit = Δ interest X Gap
Δ profit = __% X $___ million = $___ million
Result
If a bank has more rate-sensitive liabilities than
assets, a rise in interest rates reduces bank profits,
while a decline in interest rates raises profits.
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The Effect of a change interest on Profits
RSL > RSA RSA > RSL RSA = RSL
Increase in i
Decrease in i
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Duration Analysis
- Examines the sensitivity of market value of the
bank's total assets and liabilities to changes in
interest rates.
- Uses the average duration of assets and liabilities to
measure the change in net worth for a given change
in the interest rate.
Assumptions:
- Average duration of assets 3 years and liabilities 2.
- Assets are $100 million and liabilities are $90
million.
Dr. Reyadh Faras
Example
If interest rate rises by 5%.
Δ Net Worth = Δ $ assets - Δ $ Liabilities
% Δ Assets = - Δ interest X Average Asset duration
= _____% X ______= _____%
Δ $ Assets = % Δ Assets X $ Assets
= _______% X $______ = $_______
Dr. Reyadh Faras
% Δ Liab’s = - Δ interest X Average Liab’s duration
= _____% X _____= ____%
Δ $ Liab’s = % Δ Liab’s X $ Liab’s
= _______% X $______ = $_______
Δ Net Worth = $ _____ - $ ______ = $ _______
- However, a 5% decline in interest rates _____ net
worth by $_____.
Dr. Reyadh Faras
The Effect of a change interest on Capital
AD > LD
AD < LD
Increase in i
Decrease in i
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AD = LD
Managing Credit Risk
1. Screening and Monitoring
- Screening
- Specialization in Lending
- Monitoring and Enforcement of Restrictive Covenants
2. Long-Term Customer Relationships
3. Loan Commitments
4. Collateral and Compensating Balances
5. Credit Rationing
Dr. Reyadh Faras
Off-Balance-Sheet Activities
1. Loan sales
2. Generation of Fee income from
A.
B.
C.
D.
Foreign exchange trades for customers
Servicing mortgage-backed securities
Guarantees of debt
Backup lines of credit
3. Trading Activities and Risk Management Techniques
A. Financial futures
B. Financial options
C. Foreign exchange
D. Swaps
Dr. Reyadh Faras