© 2008 Pearson Education Canada9.1 Chapter 9 Banking and the Management of Financial Institutions

© 2008 Pearson Education Canada9.1

Chapter 9Chapter 9Banking and the Management of Financial Institutions


The Bank Balance SheetThe Bank Balance Sheet


LiabilitiesLiabilities

• Demand and Notice Deposits

• Fixed – Term Deposits

• Borrowings

• Bank capital


AssetsAssets

• Cash reserves

• Deposits at Other Banks

• Cash Items in Process of Collection

• Securities

• Loans

• Fixed and Other Assets


Basic Banking—Cash Basic Banking—Cash DepositDeposit

• Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in chequable deposits

First Bank First Bank

Assets Liabilities Assets Liabilities

Vault Cash

+$100 Chequable deposits

+$100 Reserves +$100 Chequable deposits

+$100


Basic Banking—Cheque Basic Banking—Cheque DepositDeposit

When a bank receives

additional deposits, it

gains an equal amount of reserves;

when it loses deposits,

it loses an equal amount of reserves

First Bank Second Bank


Reserves +$100 Chequable deposits

+$100 Reserves -$100 Chequable deposits

-$100

First Bank

Assets Liabilities

Cash items in process of collection

+$100 Chequabledeposits

+$100


Basic Banking—Making a Basic Banking—Making a ProfitProfit

• Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

• The bank borrows short and lends long

First Bank First Bank


Desired reserves


+$100 Desired reserves


+$100

Excess reserves

+$90 Loans +$90


Bank ManagementBank Management

• Liquidity Management

• Asset Management

• Liability Management

• Capital Adequacy Management

• Credit Risk

• Interest-rate Risk


Liquidity Management: Liquidity Management: Ample Excess ReservesAmple Excess Reserves

• If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet


Reserves $20M Deposits $100M Reserves $10M Deposits $90M

Loans $80M Bank Capital

$10M Loans $80M Bank Capital

$10M

Securities $10M Securities $10M


Liquidity Management: Liquidity Management: Shortfall in ReservesShortfall in Reserves

• Reserves are now short of the desired amount and the shortfall must be eliminated

• Excess reserves are insurance against the costs associated with deposit outflows


Reserves $10M Deposits $100M Reserves $0 Deposits $90M

Loans $90M Bank Capital

$10M Loans $90M Bank Capital

$10M

Securities $10M Securities $10M


Liquidity Management: Liquidity Management: BorrowingBorrowing

• Cost incurred is the interest rate paid on the borrowed funds

Assets Liabilities

Reserves $9M Deposits $90M

Loans $90M Borrowing $9M

Securities $10M Bank Capital $10M


Liquidity Management: Liquidity Management: Securities SaleSecurities Sale

• The cost of selling securities is the brokerage and other transaction costs

Assets Liabilities


Loans $90M Bank Capital $10M

Securities $1M


Liquidity Management: Liquidity Management: Bank of Canada AdvancesBank of Canada Advances

• Borrowing from the Bank of Canada also incurs interest payments based on the discount rate

Assets Liabilities


Loans $90M Advance Bank of Canada

$9M

Securities $10M Bank Capital $10M


Liquidity Management: Liquidity Management: Reduce LoansReduce Loans

• Reduction of loans is the most costly way of acquiring reserves

• Calling in loans antagonizes customers

• Other banks may only agree to purchase loans at a substantial discount

Assets Liabilities


Loans $81M Bank Capital $10M

Securities $10M


Asset Management: Three Asset Management: Three GoalsGoals

• Seek the highest possible returns on loans and securities

• Reduce risk

• Have adequate liquidity


Asset Management: Four Asset Management: Four ToolsTools

• Find borrowers who will pay high interest rates and have low possibility of defaulting

• Purchase securities with high returns and low risk

• Lower risk by diversifying

• Balance need for liquidity against increased returns from less liquid assets


Liability ManagementLiability Management

• Recent phenomenon due to rise of money center banks

• Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)

• Checkable deposits have decreased in importance as source of bank funds


Capital Adequacy Capital Adequacy ManagementManagement

• Bank capital helps prevent bank failure

• The amount of capital affects return for the owners (equity holders) of the bank

• Regulatory requirement


Capital Adequacy Management: Capital Adequacy Management: Preventing Bank FailurePreventing Bank Failure

High Bank Capital Low Bank Capital



Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M

High Bank Capital Low Bank Capital



Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M


Capital Adequacy Management: Capital Adequacy Management: Returns to Equity Holders (skip)Returns to Equity Holders (skip)

Return on Assets: net profit after taxes per dollar of assets

ROA = net profit after taxes

assetsReturn on Equity: net profit after taxes per dollar of equity capital

ROE = net profit after taxes

equity capital

Relationship between ROA and ROE is expressed by the

Equity Multiplier: the amount of assets per dollar of equity capital

EM =Assets

Equity Capital

net profit after taxes

equity capitalnet profit after taxes

assets assets

equity capital

ROE = ROA EM


Capital Adequacy Capital Adequacy Management: SafetyManagement: Safety

• Benefits the owners of a bank by making their investment safe

• Costly to owners of a bank because the higher the bank capital, the lower the return on equity

• Choice depends on the state of the economy and levels of confidence

• Bank capital requirement


Strategies for LoweringStrategies for Lowering Bank Capital Bank Capital

1. Buying back some of Bank’s stock

2. Pay out higher dividend to shareholders

3. Acquire new funds and increase assets


Strategies for RaisingStrategies for Raising Bank Capital Bank Capital

1. Issue more common stock

2. Reducing dividend to shareholders

3. Issue fewer loans or sell securities and use proceeds to reduce liabilities


Off-Balance-Sheet Off-Balance-Sheet ActivitiesActivities

• Loan sales (secondary loan participation)

• Generation of fee income

• Trading activities and risk management techniques– Futures, options, interest-rate swaps, foreign

exchange

– Speculation


Off-Balance-Sheet Off-Balance-Sheet Activities Activities (Cont’d)(Cont’d)

• Trading activities and risk management techniques (continued)

– Principal-agent problem

– Internal Controls

• Separation of trading activities and bookkeeping

• Limits on exposure

• Value-at-risk

• Stress testing


Measuring Bank Measuring Bank Performance Performance


Measuring Bank Measuring Bank Performance Performance (Cont’d)(Cont’d)

• Operating Income

• Operating Expenses

• Net Operating Income

• Net Income


Measuring Bank Measuring Bank Performance (skip)Performance (skip)

ROA = net income/assets

ROE = net income/equity capital

NIM = (interest income-interest expenses)/assets

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© 2008 Pearson Education Canada9.1 Chapter 9 Banking and the Management of Financial Institutions