Principles of Bank Management_1

8/2/2019 Principles of Bank Management_1

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Principles of BankManagement

-Principles of Banking-


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Outline

The financial statements of a bankPrinciples of bank managementMeasuring and evaluating bank performanceManaging bank sources of funds


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Part I: The bank firm andbank performanceIntroduction to:

Bank balance sheet Process of asset transformation Bank income statement

Measuring and evaluating bank performance Banks objectives ROE ROA


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Banks main business

Accept deposits from customers: Offer different types of deposit products:

Savings, demand, time, etc

Cash ISAs (tax-free) Make Loans to customers:

Overdrafts (payable on demand) Fixed term loans (incl. Mortgages)

These transformations create various risks: liquidity risk, creditrisk, interest rate risk


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Banks balance sheet

Total Assets

(Uses of funds)

Total Liabilities and Equity

(Sources of funds)

Loans and overdrafts Deposits with other banks Items in collection Notes and coins Treasury bills and other

securities

Reserves Other assets (premises and

equipment)

Demand deposits Savings deposits Time deposits Borrowings OtherBank Capital

Shareholders capital Loan loss reserves


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Balance sheet of all commercial banks (itemsas a percentage of the total, Jan 2012)

Assets (Uses of funds) Liabilities (Sources of funds)

Reserves and cash itemsSecurities

U.S. government and agencyState and local government and other

securitiesLoans

Commercial and Industrial

Real estateConsumer

Interbank

OtherOther assets (e.g. physical capital)

Checkable depositsNon-transaction deposits

Small-denomination time depositsLarger-denomination time deposits

BorrowingsBank Capital

Total Total


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Assets (Bank uses of funds)

Cash in the vault and deposits held at otherdepository institutions (C)

Government and private interest-bearingsecurities purchased in the open market (S)

Loans and lease financing made available tocustomers (L)

Miscellaneous assets (MA)


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The cash account

Cash held in the banks vaultCorrespondent deposits (placed with other banks)Cash items in the process of collection (mainly

uncollected checks)

The banks reserve account held with the centralbank in the region (primary reserves)


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Investment securities

The liquid portion (secondary reserves)Short-term government securities (government

and municipal)

Privately issued money market securities Interest-bearing time deposits Commercial paper

The income generating portion:Bonds, notes and other securitiesTrading account securities


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Loans

The largest asset itemGross loans: sum of all outstanding IOUs owned

to the bankAllowance for possible loan losses (ALL)


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Other assets

Customers liability on acceptancesMiscellaneous assets

Net value of bank buildings and equipmentPrepaid insuranceOther relatively insignificant asset items


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Liabilities and equity capital(sources of funds) Deposits (D)

non interest-bearing demand deposits (checking accounts) Savings deposits NOW accounts Money market deposit accounts (MMDAs) Time deposits (mainly CDs)

Non-deposit borrowings of funds (NDB) Short-term borrowings Long-term borrowings

Equity capital (EC) Capital surplus Retained earnings Contingency reserve


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Banks balance sheet

C + S + L + MA = D + NDB + EC

Accumulated uses of bank funds (Assets) =Accumulated sources of bank funds (Liabilitiesand Equity Capital)


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Off-balance sheet activities

Standby credit agreements (L/C) Interest rate SWAPS Futures and Options Loan commitments Foreign exchange rate contracts


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Income Statement

Financial inflows Financial outflows

Loan incomeSecurity income

Income from cash assetsMiscellaneous income

Deposit costsNon-deposit borrowing costs

Salaries and wages expenseMiscellaneous expenses

Tax expense

Total operating income Total operating expense

Operating profit before provisions = total operating income totaloperating expenses

Provisions for loan losses, contingent liabilities and commitments Operating profit = Operating profit before provisions- provisions Operating profit after tax = Operating profit- tax on profit

Operating profit after tax between dividends and retained earnings


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Income statement Bank revenue items

Loans (L) Securities (S) Interest-bearing deposits (C) Miscellaneous assets (M)

Bank expense items Interest paid out to depositors (D) Interest owed on non-deposit borrowings (NDB) The cost of equity capital (EC)

Salaries, wages, benefits paid to bank employees (SWB) Overhead expenses (O) Funds set aside for PLL (PLL) Taxes owed (T) Miscellaneous expenses (ME)


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Income instatement

Net income = Total revenue items total expense itemsNet income = (Crcash + Srsec + Lrloans + MrM) (Did +

NDBindb + ECiec + SWB + O + PLL + ME + T)


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Exercise Fill in the missing items from its statement shown below

First banks Balance sheet ($ million)

Assets Liabilities

Cash and deposits due from banksInvestment securitiesTrading account securities

Federal funds soldLoan, gross

Allowance for loan lossUnearned discount on loansLoans, net

Bank premises and equipmentCustomers liability on acceptances

Miscellaneous assetsTotal Assets

?876

11?

(19)(6)348

1018

43$550

Non interest-bearing demand depositsSavings deposits and NOW accountsMoney market deposit accounts

Time depositsDeposits at foreign branches

Total DepositsNon deposit borrowingsOther liabilities

Stockholders equity capital

Total liabilities and equity capital

$107?49

227?

2144041

19?

$550

Income statement

Interest and fees on loansInterest on investment securities

Other interest incomeTotal interest incomeTotal interest expense

Net interest incomeProvision for loan losses

?7

5$180$159

?4

Service charges on customer depositsTrust department income

Other operating incomeTotal noninterest incomeWages, Salaries, and employee benefits

Net occupancy and equipment expenseOther expensesTotal noninterest expenses

Net noninterest income

?8

2039?

7554

?

Provision for income taxes 2Net income (or loss) after taxes ?


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Asset Transformation

Banks issue liabilities with certain liquidity, risk and returncharacteristics

E.g. most bank deposits are redeemable on demand, have low riskand pay the holder a given deposit rate

The bank uses the proceeds to acquire loans with a different setof characteristics

Example Bank raises 100k of onemonth notice time deposits and makes a

25year mortgage loan (maturity transformation: banks borrow

short and lend long)


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Basic Banking Cash deposit

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault Cash +100 Checkabledeposit +100

Reserves +100 Checkabledeposits +100

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +100 Checkabledeposit +100 Reserves -100 Checkabledeposits -100


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Basic Banking Making a Profit

First National Bank

Assets Liabilities

Required Reserves+10

Checkabledeposits +100

Excess Reserves+90

First National Bank

Assets Liabilities

RequiredReserves +10

Checkabledeposits +100

Loans +90


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Basic Banking--Required Reserves

$10 of the deposit must remain in reserves to meet federalregulations (10% reserve req.).

Now, the bank is free to work with the $90 in its assettransformation function. In this case, the bank loans the $90to its customers.

First Nati onal Bank

Assets Liabilities

Required reserves

Excess reserves

+$10

+$90

Checkable

deposits

+$100

Deposit of $100 cash into First National Bankassume Required Reserve ratio of 10%


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Basic Banking

Loaning out excess reservesFirst National Bank

Assets Liabilities

Required reserves

Loans

+$10

+$90

Checkable

deposits

+$100


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Bank Management Aims

A banks objective is to maximise profit while remaining safeand sound:

Must manage assets and liabilities in order to achieve maximumprofit

Asset management aims at: Earning highest possible return from assets at a minimal level of

risk:

risk of individual assets (e.g. loans) minimised well diversified portfolio of assets

Utilises methods such as credit risk and interest rate riskmanagement

Liability management aims at: Acquiring funds at lowest cost


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Bank Management Aims

Liquidity management Banks must be able to meet deposit outflows Involves predicting daily withdrawals and keeping sufficient cash

to meet them

Capital adequacy management bank must be able to sustain some loan losses in order to remain

solvent

meet regulators demands (Basle Accord stipulates a ratio of 8%of bank capital to assets)

Offbalance sheet (OBS) management Bank must control and limit exposures from offbalance sheet

transactions (e.g. derivative instruments)

OBS generate contingent liabilities, in extreme circumstancesmay result in a bank failing (e.g. Barings Bank)


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Principles of Bank ManagementLiquidity Management

Reserves requirement = 10%, Excess reserves = $10 millionAssets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million

With 10% reserve requirement, bank still has excess reserves of $1million: no changes needed in balance sheet

Deposit outflow of $10 millionAssets Liabilities




Deposit outflow- 10 m- 10 m


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Liquidity Management

With 10% reserve requirement, bank has $9 million reserveshortfall

No excess reserves

Assets Liabilities




Deposit outflow of $10 millionAssets Liabilities




- 10 m- 10 m


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1. Borrow from other banks or corporationsAssets Liabilities


Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million

2. Sell securitiesAssets Liabilities




+ 9 m+ 9 m

+ 9 m- 9 m


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Excess reserves are insurance against above 4 costs fromdeposit outflows

3. Borrow from FedAssets Liabilities


Loans $90 million Discount Loans $9 million

Securities $10 million Bank Capital $10 million

4. Call in or sell off loansAssets Liabilities


Loans $81 million Bank Capital $10 millionSecurities $10 million

+ 9 m+ 9 m

+ 9 m- 9 m


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Asset Management

A banks asset portfolio can be thought of as an ordinaryportfolio of assets with different riskreturn characteristics

Applying modern portfolio theory suggests deriving an efficientportfolio frontier in the risk

return space (diversification to

eliminate idiosyncratic risk)

Choosing among efficient portfolios according to attitudetowards risk

However, risk of individual assets is unknown because ofimperfect information credit risk analysis


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Credit Risk

Basel Committee on Banking Supervisiondefines credit risk as:

the potential that a bank borrower or counterparty willfail to meet its obligations in accordance with agreed

terms.

More simply, it is the risk that a loan is not repaid (inpart or in full)

Banks face credit risk not only for loans but alsofor OBS instruments like derivatives, where it is

known as counterparty risk.


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Credit risk management

Adverse selection and moral hazard are endemic incredit markets. To address them banks engage in:

Screening loan applicants Monitoring and restrictive covenants Specialisation in lending Longterm customer relationships Collateral and compensating balances Credit rationing


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Liability Management

Liability Management: managing the source offunds, from deposits, to CDs, to other debt.

Importance has grown dramatically No longer primarily depend on deposits When loan opportunities exist, borrow or issue CDs

to acquire funds


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Quiz

Define Bank Capital

Explain the advantages and disadvantages ofmaintaining a large amount of bank capital.


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Capital Adequacy Management

Bank capital is a cushion that prevents bank failure Consider these two banks:

High Capital BankAssets Liabilities

Reserves $10 million Deposits $90 millionLoans $90 million Bank Capital $10 million

Low Capital Bank

Assets Liabilities




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What happens if these banks make loans or invest insecurities (say, subprime mortgage loans, for example)

that end up losing money? Lets assume both banks lose

$5 million from bad loans.


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Impact of $5 million loan loss

High Capital BankAssets Liabilities



Low Capital BankAssets Liabilities


Loans $85 million Bank Capital -$1 million

A bank maintains capital to lessen the chance thatit will become insolvent.


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Why dont banks hold want to hold a lot

of capital?

Higher is bank capital, lower is return onequity

ROA = Net Profits/Assets ROE= Net Profits/Equity Capital EM = Assets/Equity Capital ROE= ROAEM Capital , EM, ROE


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Tradeoff between safety (high capital) andROE

Banks also hold capital to meet capitalrequirements

The Basel Committee on Banking Supervision setsminimum capital requirements the ratio of bank

capital to risk weighted assets

A d it li d it l


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An under-capitalised capitalbank faces loan default

Assets (m) Liabilities (m)

ReservesCash at Vault

Deposits with CB

5010

40

Deposits 70

Loans 740 Bank capitalLoan loss reserves

Shareholderscapital

4020

20

SecuritiesTreasury Bills

Other bonds

00

0

Borrowings fromother banks

50


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Interest rate risk

First National Bank

Assets Liabilities ($m)

Rate-sensitive assets 200M Rate-sensitive liabilities 500M

Variable rate and short-term loans Variable-rate CDs

Short-term securities Money market deposit accounts

Fixed-rate assets 800M Fixed-rate liabilities 500M

Reserves Checkable deposits

Long-term loans Savings deposits

Long-term securities Long-term CDs

Equity capital

If the bank has more rate-sensitive liabilities than assets, a rise in interest

rates will reduce bank profits and a decline in interest rates will raise

bank profits

H d b k


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How do banks manageinterest rate risk Gap analysis

Subtract the amount of interest rate-sensitive liabilities form theamount of interest rate-sensitive assets

Multiply the gap by the change in interest rate Obtain the effect on profit

Maturity bucket approach Basic gap analysis useful for illustrative purposes In reality, assets and liabilities have different maturities Carry out gap analysis at each maturity

M i I t t t i k i


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Measuring Interest rate risk inpractice

Maturity Assets

(m)

Liabilities

(m)

Incremental

GAP (m)

Cumulative

GAP (m)

INTEREST

RATE RISK

(annualised)

+5% -5%

0-7 days 10 15 -5 -5 -0.25 +0.25

7-90 days 20 260 -240 -245 -12.25 +12.25

3-12months 50 385 -335 -580 -29.00 +29.00

1-2 years 120 200 -80 -660 -33.00 +33.00

2-5 years 300 60 240 -420 -21.00 +21.00

5+ years 500 80 420 0 0.00 0.00

Total 1000 1000


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How is interest rate risk reduced?

Maturity Assets

(m)

Liabilities

(m)

Incremental

GAP (m)

Cumulative

GAP (m)

INTEREST

RATE RISK

(annualised)

+5% -5%

0-7 days 10 15 -5 -5 -0.25 +0.25

7-90 days 20 260 -240 -245 -12.25 +12.25

3-12months 50 385 -335 -580 -29.00 +29.00

1-2 years 120 200 -80 -660 -33.00 +33.00

2-5 years 300 60 240 -420 -21.00 +21.00

5+ years 500 80 420 0 0.00 0.00

Total 1000 1000

Reduce or eliminate gaps (matching)

M i I t t t i k


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Managing Interest rate risk:Matching

Maturity Assets

(m)

Liabilities

(m)

Incremental

GAP (m)

Cumulative

GAP (m)

INTEREST

RATE RISK

(annualised)

+5% -5%

0-7 days 10 15 -5 -5 -0.25 +0.25

7-90 days 20 260 -240 -245 -12.25 +12.25

3-12months 250 385 -135 -380 -19.00 +19.00

1-2 years 120 200 -80 -460 -23.00 +23.00

2-5 years 100 60 40 -420 -21.00 +21.00

5+ years 500 80 420 0 0.00 0.00

Total 1000 1000

U i d i ti t


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Using derivatives to manageInterest rate risk Matching assets and liabilities has disadvantages:

It is a costly way of managing interest rate risk Prevents banks from issuing fixed interest rate loans, which

are attractive to customers

Interest rate swaps offer a better alternative: Can convert fixed rate assets into rate sensitive assets at

relatively low transaction costs

Consider the hypothetical balance sheet: Assume it corresponds to Bank A Assume there is a Bank B that has 200m variablerate loans

it wants to convert to 5year fixedrate loans.


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An Interest rate SWAP

Bank A has 200m of 5-year fixed rate loans, which it wants toswap for 200m of variable rate loans

Bank B has 200m of variable rate loans, which it wants toswap with 5-year fixed rate loans

An intermediary matches Bank A and Bank B, for a fee The Banks enter a contract to exchange interest payments on a

notional principal of 200m swap interest payments

Bank A Bank B

Fixed rate over 5 year periodAt 7% p.a. 200m

Variable rate (bank rate + 1%)200m for 5 years

R d i i t t t i k


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Reducing interest rate riskwith a SWAP

Maturity Assets

(m)

Liabilities

(m)

Incremental

GAP (m)

Cumulative

GAP (m)

INTEREST

RATE RISK

(annualised)

+5% -5%

0-7 days 10 15 -5 -5 -0.25 +0.25

7-90 days 220 260 -40 -45 -2.25 +2.25

3-12months 50 385 -335 -380 -19.00 +19.00

1-2 years 120 200 -80 -460 -23.00 +23.00

2-5 years 100 60 40 -420 -21.00 +21.00

5+ years 500 80 420 0 0.00 0.00

Total 1000 1000


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Market risk and VaR

VaR attempts to answer the following question: How much money could the bank lose from itsportfolio of securities over the next week/month/year

with a given probability VaR is a useful summary measure for both bank

managers and regulators

Its usefulness depends on the accuracy of calculations.


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Operational risk

Basle Committee defines operational risk as: the risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events

It is very hard to quantify as it captures a whole range ofinternal and external factors such as: failure of computer

systems, rogue traders or genuine human error

M i d l ti


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Measuring and evaluatingbank performance Banks long-term objective: maximizing the value of

the firm

Value of the banks stock = Expected stream of futurestockholder dividends/Discount factor

If the dividends a bank pays its stockholders areexpected to grow at a constant rategover time:

P0 = D1/(r-g)


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Profitability ratios

Return on Equity capital (ROE) = Net income after taxes/ Total equitycapital (1)

Return on Assets (ROA) = Net income after taxes/ Total assets (2) Net interest margin = (Interest income from loans and security investments

Interest expense on deposits and on the other debt issued)/Total assets (3) Net noninterest margin = (Noninterest revenues Noninterest expenses)/

Total assets (4)

Net bank operating margin = (Total operating revenues Total operatingexpenses)/Total assets (5)

Earnings per share (EPS) = Net income after taxes/Common equity sharesoutstanding (6)

Earnings spread = Total interest income/Total earning assets Totalinterest expense/Total interest-bearing bank liabilities (7)


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Closer analysis

ROE = ROA Total assets/Total equity capital (8) ROE = [(Total revenues total operating expenses taxes)/

Total assets] Total assets/Total equity capital

ROE = (Net income after taxes/Total Operating revenue) (Total operating revenue/Total assets) (Total assets/Totalequity capital)

ROE = Net profit margin (NPM) Asset utilization ratio (AU) Equity multiplier (EM) (9)


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Measuring risk

Credit riskLiquidity riskMarket risk

Interest rate riskEarning riskSolvency risk


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Credit risk

Nonperforming assets/Total loans and leasesNet charge-offs of loans/Total loans and leasesThe annual provision for loan losses/Total loansand leases (or equity capital)

Allowance for loan losses/Total loans and leases(or equity capital)

Total loans/ total deposits


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Liquidity risk

Purchases funds (Eurodollars, federal funds,security RPs, large CDs, commercial paper/ Total

assets

Net loans/ Total assetsCash and due-from deposit balance held at otherbanks/ Total assets

Cash assets and government securities/ Totalassets


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Interest rate risk

Interest sensitive assets/Interest sensitive liabilities Uninsured deposits/Total deposits


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Solvency (default) risk

The interest rate spread between market yields on bankdebt issues and the market yields on government

securities of the same maturity

Banks stock price/EPS Equity capital (net worth)/Total assets Purchased funds/Total liabilitiesEquity capital/Risk assets (loans and securities andexclude cash, plant and equipment, and miscellaneous

assets)


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Other forms of risk

Inflation riskCurrency or exchange rate riskCrime risk

Political risk

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Principles of Bank Management_1