Ch 9: General Principles of Bank Management
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1.
2.
3.
4.
1.
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How the bank manages its assets and liabilities to earn the
highest possible profits?
The manager of the bank has 4 primary concerns:
Liquidity management.
Asset management.
Liability management.
Capital adequacy management .
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.
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Example:
-RRR (10%), Bank ONE initial balance sheet:
Assets
Reserves (RR=10,ER=10) 20
Loans
80
Securities 10
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Liabilities
Deposits 100
Capital
10
The required reserve is (10), but total reserves = (20),
therefore, the bank has excess reserves = (10)
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If a deposit outflow of (10) occurs, the bank’s
balance sheet becomes:
Assets
Reserves (RR=9,ER=1) 10
Loans
80
Securities 10
Liabilities
Deposits
Capital
90
10
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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.
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But what if the bank holds insufficient excess reserves?
 Example:
 The bank holds no excess reserves:
Bank ONE
Assets
Liabilities
RR
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 = ER = (0)
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If (10) deposit outflow occurs:
Assets
RR
-9
Loans
90
Securities 10
Liabilities
Deposits
Capital
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 !
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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:
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Assets
Reserves 9
Loans
90
Securities 10
Liabilities
Deposits
90
Borrowing from other banks or corp. 9
Capital
10
Pays interest = Federal Fund Rate
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2. Sell securities:
 Sell securities worth (9), the balance sheet becomes:
Assets
Liabilities
Reserves 9
Deposits
90
Loans
90
Capital 10
Securities 1
Cost= Liquidation, brokerage…
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3. Borrowing from the Fed:
Assets
Reserves
Loans
Securities
Liabilities
9
90
10
Deposits
90
Discount loans from the Fed 10
Capital
10
Pays interest = Discount rate.
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4. Calling in or selling loans:
 Reducing its loans by (9) and depositing the (9):
Assets
Reserves
Loans
Securities
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9
81
10
Liabilities
Deposits
Capital
90
10
This solution is costly :
May not be able to renew loans of some clients
Sell loans at lower values
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This shows why a bank holds excess reserves
though reserves pay no interest: to face
deposits outflow.
Excess reserves are insurance against the cost
associated with deposits outflows .
The higher the costs associated with deposit
outflows, the more excess reserves bank will
want to hold.
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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).
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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.
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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
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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).
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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 .
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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
Reserves
10
Loans
90
Liabilities
Deposits
Bank Capital
96
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If the two banks lose % 5 million of their loans, their assets and capital17
will decline too by the same amount.
The new balance sheets become as follows:
High Capital Bank
Assets
Reserves
10
Loans
85
Liabilities
Deposits
Bank Capital
90
5
Low Capital Bank
Assets
Liabilities
Reserves 10
Deposits
96
Loans
85
Bank Capital
-1
The high capital bank is still in a good situation because its net
worth (capital) is still positive ($5 million).
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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.
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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.
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B .Return on Equity (ROE):
ROE = net profit after taxes / equity capital
 The ROE shows how much the bank earns on
equity investment.
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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)
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ROE = (ROA) X (EM)
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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.
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Example
• The high capital bank has an EM = 10
(100 / 10) = 10
• The low capital bank has an EM = 25
(100 / 4) = 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%
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• 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(
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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.
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Tradeoff :High bank capital reduces
possibility of bankruptcy, but lowers (ROE)
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3- Bank Capital Requirements:
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Banks hold capital because they are required by
law to do so.
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1.
2.
3.
4.
5.
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
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Screening and the problem of Adverse Selection
in loan market:
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When bad credit risk (most likely to default) are the
ones who try to get loans.
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Investors with risky assets are the most eager to
obtain loans, but are the least desirable borrowers.
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Must collect information about potential borrowers.
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Moral Hazard in loan market:
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borrowers may engage in undesirable
activities from the lender’s point of view .
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Managing Interest-Rate Risk
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High volatility in interest rates makes banks
exposed to interest- rate risk:
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The risk of earnings and returns that is
associated with changes in interest rates.
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Example:
First National Bank
Assets
Liabilities
Rate-sensitive Assets
Rate-sensitive Liabilities
Fixed -rate Assets
Fixed-rate 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.
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If interest rate rises from 10% to 15% (∆ 5%):
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 ($1 - $2.5)
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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.
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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:
(Rate sensitive Assets - Rate sensitive liabilities)
 In the example above, the gap equals $30 million
($20 - $50)
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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.
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2- Duration Analysis
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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.
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Duration analysis uses the average duration of
assets and liabilities to see how the net worth
responds to a change in interest rates.
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To measure the effect of bank's net worth due to
a change in interest rate:
%∆ in market value =
(- % ∆ in interest rate x Duration)
Do the same so A-L
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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.
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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.
Or: (-5% X 3 X 100) - (-5% X 2 X 9)
= -15 + 9 = -6!
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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?
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Off-Balance-Sheet Activities
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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.
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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…
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3- Trading Activities and Risk management
Techniques:
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International Banking
Trading in financial markets
Speculations
Risky activities: Insolvency.
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