Copyright 2011 Pearson Canada Inc. 13 - 1 Chapter 13 Banking and the Management of Financial Institutions

Copyright 2011 Pearson Canada Inc. 13 - 1

Chapter 13

Banking and the Management of Financial Institutions


The Bank Balance Sheet

• It is a list of the bank’s assets and liabilities• This list balances. That is, it has the

characteristic thatTotal Assets = Total Liabilities + Capital

• A bank’s balance sheet is also a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets).


Liabilities I

• Demand and Notice Deposits• Fixed – Term Deposits• Borrowings

– Overdraft loans (advances)– Settlement balances

• Bank capital


Assets I

• Reserves– Vault cash– Desired reserves– Banker’s risk– Desired reserve ratio


Assets II

• Cash Items in Process of Collection– Items in transit (bank float)

• Deposits at Other Banks– Interbank deposits

• Securities– Secondary reserves

• Loans• Other Assets


The Bank Balance Sheet


Basic Banking I

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

First Bank Business

Assets Liabilities Assets Liabilities

Loans +$100 Chequable deposits

+$100 Chequable Deposits

+$100 Bank Loans +$100

First bank makes a loan of $100 to a business and credits the business's chequable deposit.


Basic Banking II

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

When a bank receives additional deposits, it gains an equal amount of reserves: when it loses deposits, it loses an equal amount of reserves


Basic Banking—Making a Profit

• 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

+$10 Chequable deposits

+$100 Desired reserves

+$10 Chequable deposits

+$100

Excess reserves

+$90 Loans +$90


Bank Management

• Liquidity Management• Asset Management• Liability Management• Capital Adequacy Management• Credit Risk• Interest-rate Risk


Liquidity Management and the Role of 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

with deposit outflow of $10 million

↓


Liquidity Management: Shortfall 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

with deposit outflow of $10 million

↓


Liquidity Management: Borrowing

• 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

Borrowing $9 million from other banks


Liquidity Management: Securities Sale

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

Assets Liabilities


Loans $90M Bank Capital $10M

Securities $1M

Can meet shortfall by selling $9 million of its securities


Liquidity Management: Bank 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

Borrow $9 million from the Bank of Canada


Liquidity Management: Reduce 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 Goals

• Seek the highest possible returns on loans and securities

• Reduce risk

• Have adequate liquidity


Asset Management: Four Tools

• 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 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 Management

• 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: Preventing 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: Returns to Equity Holders

EM x ROA ROEcapital equity

assetsassets

taxes after profit netcapital equity

taxes after profit netCapital Equity

AssetsEM

capital equityof dollar per assetsof amount the :Multiplier Equity the by expressed is ROE and ROA between ipRelationsh

capital equitytaxes after profit net

ROE

capital equityof dollar per taxes after profit net:Equity on Returnassets

taxes after profit netROA

assetsof dollar per taxes after profit net:Assets on Return

x


Capital Adequacy Management: 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 Managing Bank Capital

Lowering Bank Capital:• Buying back some of Bank’s stock• Pay out higher dividend to shareholders• Acquire new funds and increase assetsRaising Bank Capital:• Issue more common stock• Reducing dividend to shareholders• Issue fewer loans or sell securities and use

proceeds to reduce liabilities


Managing Credit Risk I

• A major component of many financial institutions business is making loans

• To make profits, these firms must make successful loans that are paid back in full

• The concepts of moral hazard and adverse selection are useful in explaining the risks faced when making loans


Managing Credit Risk II

• Adverse selection is a problem in loan markets because bad credit risks (those likely to default) are the one which usually line up for loans

• Those who are most likely to produce an adverse outcome are the most likely to be selected


Managing Credit Risk III• Moral hazard is a problem in loan markets

because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view

• Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful

• The high risk, however, makes it less likely the loan will be repaid.


Managing Credit Risk IV• To be profitable, lending firms must overcome

adverse selection and moral hazard problems

• Attempts by the lending institutions to solve the problems explains a number of principles for managing risk


Principles for Managing Credit Risk

• Screening and Monitoring– Screening

– Specialization in Lending

– Monitoring and Enforcement of Restrictive Covenants

• Long-term Customer relationships

• Loan Commitments

• Collateral and Compensating Balances

• Credit Rationing


Interest Rate Risk

• If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income

• If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income


Gap Analysis

• The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets

GAP = rate-sensitive assets – rate-sensitive liabilities

GAP = RSA – RSL• A change in the interest rate (Δi) will change bank

income (depending on the Gap Income = GAP i


• Owners and managers care not only about the change in interest rates on income but also on net worth of the institution

• Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates

Duration Analysis I


%ΔP = - DUR x [Δi/(1+i)]

Where: P is the market value

%ΔP = (Pt+1 – Pt)/P

DUR = duration

i = interest rate

Duration Analysis II


The Duration Gap can be calculated as:

DURgap = Dura – (L/A x DURL)

Where: Dura = average duration of assets

L = market value of liabilities

A = market value of assets

Durl = average duration of liabilities

Duration Analysis III


The impact of the interest rate change on net worth (NW) as a percentage of assets can be calculated via:

Δ NW/A = -Durgap x Δi/(1+i)

Where: DURgap = duration gap

Δi = interest rate change

i = interest rate

Duration Analysis IV


Thus

Δ NW/A = -Durgap x Δi/(1+i)

Δ NW/A = -1.72 x 0.01/(1+0.10) = -0.016 = -1.6%

With assets = $100m, the fall in NW when the interest rises from 10% to 11% equals -1.6% of $100m = -$1.6M (found earlier)

Duration Analysis V


Off-Balance-Sheet Activities I

• 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 Activities II

• 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

Documents

Copyright 2011 Pearson Canada Inc. 13 - 1 Chapter 13 Banking and the Management of Financial Institutions