Banking and the Management of Financial Institutions
Commercial Banks play an important role in channeling funds from
those with excess of funds
to those with shortage of funds (productive investment opportunities).
Commercial banks are financial intermediaries.
-
Why banks are important?
How banking is conducted to earn the highest profits?
How and why banks make loans?
How banks acquire and manage funds (assets\liabilities)?
1- The Bank Balance Sheet
- Total Assets = Total Liabilities + Capital
The bank’s balance sheet lists:
Liabilities: sources of bank funds,
Assets: uses with which funds are put.
Banks obtain funds by borrowing and by issuing other
liabilities (deposits).
Banks use funds to acquire assets (securities, loans, ...)
Banks make profits by: charging an interest rate on their
holdings (securities, loans, …)
that is higher than the costs of their liabilities (deposits,…).
Balance Sheet of a Commercial Bank
Assets (Uses of Liabilities (Sources of Funds)
Funds)
Reserves + cash Checkable Deposits
items
Nontransaction deposits
Securities
Saving deposits:
Loans
- Small denomination time
Other Assets
deposits
(physical assets) - Large denomination time
deposits
Borrowings
Bank Capital
Total = X
Total = X
- Liabilities: Sources of funds. These funds are obtained by issuing
(selling) liabilities:
A. Checkable deposits:
all bank accounts that allow the owner of the account to write checks
to third party.
Checkable deposits are bank liabilities because the owner of the
deposit can withdraw
from the account funds that the bank is obligated to pay.
B. Nontransaction deposits:
The primary source off bank funds, Owner cannot write checks, but
earn higher interest
than those on checkable deposits. This includes: savings accounts
and times deposits
(small and large (CDs)).
C. Borrowings: from the central bank (discount loans) and other
commercial banks (overnight).
D. Bank Capital: the bank’s net worth: the difference between total
assets and liabilities.
Funds are raised by: selling new equity (stock) or retained earnings.
Used against a drop in banks assets.
Assets: uses of funds, the bank acquired these funds by issuing liabilities
in order to purchase
income earning assets.
A. Reserves:
Some of the funds that the bank acquire that are deposited at the
central bank
+ Currency held by the bank (vault cash).
Reserves do not pay interest but the bank do hold them because:
1- Reserve Requirements (required reserve ratio)
2- Excess Reserve
Both can be used to meet obligations when funds are withdrawn.
B. Cash items in process of collection
C. Deposits at other banks
D. Securities: an important income-earning asset: (securities: debt
instruments for commercial banks.
E. Loans: a liability for second party (individual or firm) receiving it
but considered a bank’s asset.
F. Other assets: Physical capital.
1- Basic Banking
Banks make profits by selling liabilities (of particular combination of
liquidity, risk, size, and return) and using the proceeds to buy assets
(different combination of liquidity, risk, size, and return). This is called
“asset transformation”: saving deposit transformed as mortgage loan.
-
Operations of a bank:
The T-account
The T-account: a simplified balance sheet of a bank.
Example (1):
- (X) goes to bank ONE, Open’s a checking account with 100KD.
(This is a liability on the bank):
The bank puts the 100KD into the vault so the bank assets
increase by the 100KD:
Assets
Vault
cash
Liabilities
Checkable
+100KD deposits
+100KD
- Since the vault cash is also a part of the bank’s reserves:
Assets
Reserves
+100KD
Liabilities
Checkable
deposits
+100KD
Note: the increase in the bank’s reserves = the increase in checkable
deposits
If instead, (X) opens her checking account using a check written on an
account at another bank, say bank TWO. Therefore, The final balance
sheet for the two banks:
Bank ONE
Assets
Reserves
+100KD
Liabilities
Checkable
deposits
+100KD
Bank TWO
Assets
Reserves
-100KD
Liabilities
Checkable
deposits
100KD
Note: when a bank receives additional deposits, it gains an equal amount
of reserves,
when it loses deposits, it loses an equal amount of reserves.
Example (2):
Deposit = 100KD
Required reserve ratio = 10%
Bank ONE
Assets
RR
+10KD
Liabilities
Checkable
deposits
Excess
Reserves
+90KD
+100KD
The bank is not making profits from the reserves it hold (because
reserves
pay
no
income).
Therefore, the bank must put the reserves into productive usages (i.e.
loans):
Bank ONE make loan =90KD (the excess reserve):
Bank ONE
Assets
RR
+10KD
Liabilities
Checkable
deposits
Loans
+90KD
+100KD
Since loans pay interest, the bank can make profits now.
3- General Principles of Bank Management

How the bank manages its assets and liabilities to earn the
highest possible profits?

The manager of the bank has 4 primary concerns:
1. Liquidity management.
2. Asset management.
3. Liability management.
4. Capital adequacy management.
1- Liquidity management and the role of reserve:
How the bank deals with deposit outflows?
This is when deposits are lost because depositors make withdrawals
and demand payment.
Example:
RRR (10%)
Bank ONE initial balance sheet:
Assets
Reserves
Loans
Securities
Liabilities
20 Deposits
80 Capital
10
100
10
The required reserve is (10), but total reserves = (20), therefore, the
bank has excess reserves = (10).
If a deposit outflow of (10) occurs, the bank’s balance sheet becomes:
Assets
Reserves
Loans
Securities
Liabilities
10 Deposits
80 Capital
10
90
10
The bank loses (10) of deposits AND (10) of reserves.
But since the total amount of deposits = (90), and
RRR = (10%):
Required reserve = (9), and
Excess reserve = (1).
If the bank has excess reserves, a deposits= outflow does not necessitate
changes in other parts
of its balance sheet.
But what if the bank holds insufficient excess reserves?
Example:
the bank holds no excess reserves:
Bank ONE
Assets
Liabilities
Reserves
10 Deposits
100
Loans
90 Capital
10
Securities
10
The required reserve is (10), and total reserves = (10), therefore, the
bank holds
no excess reserves = (0).
-
if (10) deposit outflow occurs:
Assets
Reserves
Loans
Securities
Liabilities
0 Deposits
90 Capital
10
90
10
There is a decline in deposits and reserves by (10).
The reserves = (0), this is a problem since the required reserve must =
(9: 10%×90).
The bank has no RESERVE.
To eliminate this problem, the bank has 4 options:
1- Borrowing from other banks (FED), or borrowing from
corporation.
The bank’s balance sheet becomes:
Assets
Reserves
Loans
Securities
Liabilities
9 Deposits
90
90 Borrowing from other
10 banks or
corp.
9
Capital
10
Pays interest = Federal Fund Rate
2- Sell securities:
Sell securities worth (9), the balance sheet becomes:
Assets
Liabilities
Reserves
9 Deposits
Loans
90 Capital
Securities
1
Cost= Liquidation, brokerage…
90
10
3- Borrowing from the Fed:
Assets
Reserves
Loans
Securities
Liabilities
9 Deposits
90 Discount Loans
10 from the Fed
Capital
Pays interest = Discount rate.
90
9
10
4- Calling in or selling loans:
Reducing its loans by (9) and depositing the (9):
Assets
Reserves
Loans
Securities
Liabilities
9 Deposits
81
10 Capital
90
10
This solution is costly:
May not be able to renew loans of some clients
Sell loans at lower values
This shows why a bank holds excess reserves though reserves pay no
interest: to face
deposits outflow.
Excess reserves are insurance against the coat associated with deposits
outflows.
The higher the costs associated with deposit outflows, the more excess
reserves
bank will want to hold.
2- Asset Management
When managing its assets (to maximize profits), the bank must:
A. Seek the highest returns on loans and securities,
B. Reduce risk,
C. Enough provisions for liquidity (holding liquid assets).
To accomplish these goals, four basic ways:
1- Find borrowers who will pay high interest rates but unlikely to
default (Screening to
reduce adverse selection problem).
2- Purchase securities with high returns and low risk.
3-Diversification of assets: purchase different type of assets, diversify
borrowers.
4- Manage liquidity to satisfy reserves requirements.
3- Liability Management
The use of liabilities in the creation of reserves and liquidity (Assets):
Before:
No interest paid on checkable deposits, therefore, no
competition for deposits between banks.
Banks rarely used overnight loans,
After:
Expansion of overnight loans
Development of new financial instruments
The flexibility in liability management means: the bank need not to
depend on checkable deposits as the primary source of funds
(liabilities).
4- Capital Adequacy Management
Capital= Bank’s net worth
= Total assets – Total liabilities
Maintaining the appropriate capital (net worth) to prevent bank
failure, maintain owners’ returns, and meet central bank regulations.
1- Prevent Bank Failure:
Example (1):
Consider two banks, one with capital to assets ratio of 10% and the
other with 4%.
High Capital Bank
Assets
Liabilities
Reserves
10 Deposits
90
Loans
90 Bank Capital
10
Low Capital Bank
Assets
Liabilities
Reserves
10 Deposits
96
Loans
90 Bank Capital
4
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
Reserves
10 Deposits
90
Loans
85 Bank Capital
5
Low Capital Bank
Assets
Liabilities
Reserves
10 Deposits
96
Bank Capital
Loans
85
1
- The high capital bank is still in a good situation because its net worth
(capital) is still
positive ($5 million).
- The low capital bank is in a bad situation because its net worth is
negative (-$1 million).
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
(creditors).
When a bank becomes insolvent, the government closes it.
2- Bank Capital Affects Returns to Equity Holders:
Bank owners need measures of bank profitability to know if the bank is
managed well or not:
A. 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.
B. Return on Equity (ROE):
ROE = net profit after taxes / equity capital
The ROE shows how much the bank earns on equity investment.
C. 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:
Net profit after taxes / Equity capital =
(net profit after taxes / assets) X (assets / equity capital)
ROE = (ROA) X (EM)
This formula show what happens to the return on equity when a bank
holds a smaller amount
of capital (equity) for a given amount of assets.
Example
The high capital bank has an EM = $100 million / $10 million = 10
The low capital bank has an EM = $100 million / $4 million = 25
If ROA is 1%, then:
ROE for the high capital bank = 1% X 10 = 10%
ROE for the low capital bank = 1% X 25= 25%
Equity holders of the low capital bank are happier because they have a
return 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.
Tradeoff: High bank capital reduces possibility of bankruptcy, but
lowers (ROE).
3- Bank Capital Requirements:
Banks hold capital because they are required by law to do so.
Managing Credit Risk
The bank must make good loans that are paid back (No default).
- Screening and Monitoring,
- Long-Term Customer Relation
- Loan commitments
- Collateral and Compensating Balances
- Credit rationing
Screening and the problem of Adverse Selection in loan market: when
bad credit risk
(most likely to default) are the ones who try to get loans. Investors with
risky assets
are the most eager to obtain loans, but are the least desirable
borrowers. Must collect information
about potential borrowers.
Moral Hazard in loan market: borrowers may engage in undesirable
activities from the lender’s
point of view.
Managing Interest-Rate Risk
High volatility in interest rates makes banks exposed to interest- rate
risk:
The riskiness of earnings and returns that is associated with changes in
interest rates.
Example:
First National Bank
Assets
Liabilities
Rate-sensitive
Rate-sensitive
Assets
Liabilities
Fixed -rate
Fixed-rate
Assets
Liabilities
- $ 20 million of assets are rate sensitive, while $80 million with fixed
rates.
- $ 50 million of liabilities are rate sensitive, while $ 50 million with
fixed rates.
- If interest rate rises from 10% to 15% (
-income on assets rises by $1 million:
in income = in interest X rate sensitive assets
= 5% X $ 20 million = $ 1 million
- payments on liabilities rise by $2.5 million:
in cost of liabilities = in interest X rate sensitive liabilities
= 5% X $ 50 million = $ 2.5 million
- The bank profit's decline by $1.5 million ($2.5 - $1).
- However, if interest rate falls by 5%, profit rises by $1.5 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.
Gap and Duration Analysis:
1-Gap Analysis: The sensitivity of bank profits to changes in interest
rates can be measured
directly using gap analysis by subtracting the amount of rate sensitive
liabilities from the amount
of rate sensitive assets.
- In the example above, the gap equals $30 million ($20 - $50)
- By multiplying the change in interest rate by the gap, we obtain the
effect on profits:
in profit = 5% X - $30 million = - $1.5 million.
"Not all assets have same maturity": Maturity bucket approach.
"Differing degrees of rate sensitivity": Standardize gap analysis.
2-Duration Analysis
- An alternative measure of interest rate risk is duration analysis, which
examines
the sensitivity of the market value of the bank's total assets and
liabilities to changes in interest rates.
- Duration analysis uses the average duration of assets and liabilities to
see how the net worth responds
to a change in interest rates.
- To measure the effect of bank's net worth due to a change in interest
rate:
%∆ in market value = ( - %∆ in interest rate) * (Duration)
- In the example above, if average duration of assets is three years and
liabilities is two years,
assets are $100 million , and liabilities are $90 million. If interest rate
rises by 5%:
Value of assets falls by 15% (- 5% X 3 years), or $15 million.
Value of liabilities falls by 10% (-5% X 2 years), or $9 million.
Net worth falls by $ 6 million, or 6% of assets.
- However, a 5% decline in interest rates increases net worth by 6% (of
total assets).
Can you show how?
Off-Balance-Sheet Activities
This involve activities that affect bank profits, but do not appear on the
bank’s balance sheet.
Trading financial instruments and generating income from fees and
loan sales.
1- Loan Sales (Secondary Loan Participation):
A contract that sells all or part of the cash stream of a loan therefore, it
removes the loan from
the bank’s balance sheet.
2- Generation of Fee Income:
Earned from providing specialized services to customers: foreign
exchange trade, mortgage
backed security, banker’s acceptance…
3- Trading Activities and Risk management Techniques:
-
International Banking
Trading in financial markets
Speculations
Risky activities: Insolvency.