BANK MANAGEMENT
BANK PERFORMANCE
CHAPTERS 19, 20
Dr. David P Echevarria
All Rights Reserved
1
BANK PERFORMANCE
EVALUATION
A. Bank Profits
1. P = Loans x Realized Loan Yield minus
Deposits x Cost per $ of Deposits - Fixed
Expenses
2. RLY = Contractual rate x Good Loan Fraction (1-Recov. rate) x Bad Loan Fraction
3. Cost of Deposits = Interest paid plus the cost of
free services
4. Fixed Costs = the cost of everything else the
bank needs to run the business
Dr. David P Echevarria
All Rights Reserved
2
BANK PERFORMANCE
EVALUATION
B. Realized Loan Yield Example
1. RLY = Contractual rate x Good Loan Fraction - (1Recov. rate) x Bad Loan Fraction
2. Consider an average rate of 12%, 90% good loans and a
recovery rate of 85% on bad loans. The RLY in this
example is 9.3%
3. RLY = .12 x .9 - (1-.85) x .10 = .093 or 9.3%
4. If the bank has a $100,000,000 portfolio, that equates to
$9,300,000 in interest income after writing off
$1,500,000 in bad loan losses (against $10,800,000
interest income)
Dr. David P Echevarria
All Rights Reserved
3
BANK PERFORMANCE
EVALUATION
C. Return on Equity: ROE = Profits / Equity
D. Methods of Increasing ROE
1. Lower Equity (increase leverage); a risky move
in a volatile environment – especially during
periods of low profitability
2. Equity Ratio = equity / loans and investments
Dr. David P Echevarria
All Rights Reserved
4
BANK PERFORMANCE
EVALUATION
3. Raise Profits by increasing revenue:
a.
b.
c.
d.
e.
f.
g.
h.
i.
Increase contractual rates
Lend more money; need to increase deposits,
Decrease free services or start charging for them
Lower variable costs
Lower fixed costs; problem of indivisibility
Tighten loan standards; could result in lowering total loan
portfolio
Offer other low-cost high margin services; i.e., brokerage,
insurance, etc
Increasing size to get benefits of scale
Securitizing collateralized loans; retaining servicing fee income
Dr. David P Echevarria
All Rights Reserved
5
BANK PERFORMANCE
EVALUATION
E. Market Considerations
1. Competition limits ability to raise loan rates,
reduce services, or reduce deposit rates
a. Increasing loan rates and decreasing deposit rates
increases the Net Interest Margin
b. Ability to make loans a function of;
(1) excess reserves or (2) required reserve ratio
2. Customers know more than the bank
a. Problem of asymmetric information
b. Adverse selection; raise rates and best quality
customers may leave
Dr. David P Echevarria
All Rights Reserved
6
BANK PERFORMANCE
EVALUATION
F.
The Risk-Return Tradeoff
1.
2.
Competition and adverse selection limit ability to increase earnings
from lending
Other investments offer higher returns but carry interest rate risk;
a.
b.
c.
G.
Rather than lending, could invest depositors cash in interest earning
securities
As interest rates change, value of the investment portfolio changes
What happens when value of the assets are less that value of liabilities?
A Final Pass on Deposits, Reserves, and Liquidity
1.
2.
3.
Increasing deposits also increases variable costs
Ability to make loans a function of excess reserves (cash in vault:
opportunity cost)
Liquidity is necessary to service client demand for cash
Dr. David P Echevarria
All Rights Reserved
7
WHY BANKS FAIL
A. The Most Frequently Given Reasons for
Bank Failure
1.
2.
3.
4.
Bank officer fraud
Excessive Bad Loans
Inadequate Liquidity / Inadequate Capital
Deregulation and Resultant Increase in
Competition
5. Regulatory forbearance
6. Non preparedness for increase in interest rate risk
Dr. David P Echevarria
All Rights Reserved
8
RECENT DEVELOPMENTS IN
BANK MANAGEMENT
B. Bank Response to New Capital Requirements
1. Issuance of new stock
2. Merger with a stronger bank
3. Shrinking the Balance Sheet.; reduction in assets, w/o
changes in equity, increases equity ratio or pushing for
acquisition by larger bank
4. Increase ratio of Risk-Sensitive Assets to Risk Sensitive
Liabilities
Dr. David P Echevarria
All Rights Reserved
9
SOURES OF RISK IN BANK
PORTFOLIOS
A.
Examining the Proportion of Rate Sensitive Assets and
Liabilities
1.
GAP Analysis → Changes in Income
a.
b.
2.
Rate Sensitive Assets:
a.
b.
c.
d.
3.
GAP = Rate Sensitive Assets (RSA) – Rate Sensitive Liabilities (RSL)
DI = GAP * Di
Short-Term Loans (Maturities 1 year or less); commercial or consumer
Variable Rate Mortgages
The proportion of fixed rate mortgages that are repaid early
The proportion of auto loans paid early
Rate Sensitive Liabilities
a.
b.
c.
Money Market Deposits
Variable Rate CDs and CDs maturing in 1 year or less
Borrowings with maturities 1 year or less
Dr. David P Echevarria
All Rights Reserved
10
RISK IN BANK PORTFOLIOS
B. Interest Rate Changes and GAP
1. If a financial institution has more rate sensitive
liabilities (RSL) than rate sensitive assets (RSA),
then the GAP will be negative:
a. GAP = RSA – RSL
b. If RSL > RSA, then GAP < 0 (negative)
2. Any increases in Interest rates will reduce the
GAP (or net interest rate margin) and result in
net income decline:
Dr. David P Echevarria
All Rights Reserved
11
RISK IN BANK PORTFOLIOS
C. Bank Profits a function of interest rate expectations
1. If interest rates expected to go up, then allocate assets to
short-term loans → rollover at higher rates
2. If interest rates expected to go down, allocate assets to
long-term loans → less rollover
D. Forecasting interest rates is important
1. Effects on GAP of Proportions of RSA and RSL
2. Magnitude of excess reserves is key to loss containment
strategy
Dr. David P Echevarria
All Rights Reserved
12
MANAGING INTEREST RATE
RISK (Gap)
A. Potential Strategies
1. Maturity matching; would drive Commercial banks to
short-term loans
2. Floating-rate loans; unpopular with borrowers
3. Financial Futures; high leverage, high risk (basis risk)
4. Interest Rate Swaps; potentially risky if wrong on
expectations or arrangements
B. The Scenarios for Interest rate Swaps
1. Long-Run increase in interest rates; decreases the gap
2. Long-Run decrease in interest rates; increases the gap
Dr. David P Echevarria
All Rights Reserved
13
MANAGING INTEREST RATE
RISK (The Gap)
C. Types of SWAPS:
1. Fixed rate for Floating Rate Swap: rates calculated at
time of swap
2. Forward Swap; setting the rates now for future swap
3. Swaptions: hybrid arrangements for early termination
a.
b.
Callable Swap: party making fixed payments option to terminate
before maturity [Desirable if interest rates decline]
Putable Swap: party making floating payments option to
terminate before maturity [Desirable if interest rates increase]
Dr. David P Echevarria
All Rights Reserved
14
RECENT DEVELOPMENTS IN
BANK MANAGEMENT
A. Banking Regulation Seeks to Reduce Financial
Shocks
1. Banks must have higher levels of capital; BIS (Bank for
International Settlements)
a.
b.
c.
Tier 1: Book Value of Stock plus retained earnings
Tier 2: Sum of Loan-Loss reserves and subordinated debt
Total capital = Tier 1 plus Tier 2
2. How much a bank must have in each category a function
of risk-adjusted assets
a.
b.
c.
d.
e.
Risk-Weighted Capital Requirements and Asset Types;
Cash and Government Securities = 0 risk weight
Loans = 1.0 risk weight
Mortgages = 0.5 weight
Inter bank deposits = 0.2 weight
Dr. David P Echevarria
All Rights Reserved
15
RECENT DEVELOPMENTS IN
BANK MANAGEMENT
3. The [Separate] Leverage Requirement
a. Tier 1 capital; 3% of all unweighted assets
b. If risky, may require 4-6%
4. Off-Balance Sheet assets not counted
Dr. David P Echevarria
All Rights Reserved
16
HOMEWORK QUESTIONS
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.
How are depository institutions' profits determined?
How does the bank realized loan yield (RLY) affected by credit policies?
If a bank has low ROE (or ROA), what strategies might it pursue?
What determines the ability of a bank to expand loan activity?
What is meant by Adverse Selection? How does it affect bank
operations?
How have banks responded to the capital requirements under the BIS
standard?
What is the single largest source of risk for banks?
What are Swaps and how do banks use them?
What are the special considerations involved in structuring Swap deals?
What are the ways banks can increase their profits?
What are the two biggest dangers they face in doing so?
Why are banks trying to get larger and to expand their activities?
Dr. David P Echevarria
All Rights Reserved
17