Ch 9: General Principles of Bank Management. 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 . - PowerPoint PPT Presentation
1 Ch 9: General Principles of Bank Management How the bank manages its assets and liabilities to earn the highest possible profits ? The manager of the bank has 4 primary concerns : 1. Liquidity management. 2. Asset management. 3. Liability management. 4. Capital adequacy management . 1. Liquidity management and the role of reserve : 2. How the bank deals with deposit outflows? 3. This is when deposits are lost because depositors make withdrawals and demand payment.
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Ch 9: General Principles of Bank Management
How the bank manages its assets and liabilities to earn the highest possible profits?
The manager of the bank has 4 primary concerns:1. Liquidity management.2. Asset management.3. Liability management.4. Capital adequacy management.
1. Liquidity management and the role of reserve:2. How the bank deals with deposit outflows?3. 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 Liabilities
Reserves (RR=10,ER=10) 20 Deposits 100Loans 80 Capital 10Securities 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 Liabilities
Reserves (RR=9,ER=1) 10 Deposits 90Loans 80 Capital 10Securities 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 ONEAssets Liabilities
RR 10 Deposits 100Loans 90 capital 10Securities 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 LiabilitiesRR -9 Deposits 90Loans 90 Capital 10Securities 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:
Assets LiabilitiesReserves 9 Deposits 90Loans 90 Borrowing from other banks or corp. 9 Securities 10 Capital
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 ManagementThe 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)(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 BankAssets Liabilities
Reserves 10 Deposits 96 Loans 90 Bank Capital 4
If the two banks lose % 5 million of their loans, their assets and capital will decline too by the same amount.
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The new balance sheets become as follows: High Capital Bank
Assets Liabilities Reserves 10 Deposits 90 Loans 85 Bank Capital 5
Low Capital BankAssets 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 efficientlyefficiently 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 earnsearns 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)
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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ExampleExample
• 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.
Tradeoff: High bank capital reduces possibility of bankruptcy, but lowers (ROE)
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3- Bank Capital Requirements:
Banks hold capital because they are required by law to do so.
Managing Credit Risk The bank must make good loans that are paid
back (No default) 1. Screening and Monitoring,2. Long-Term Customer Relation3. Loan commitments 4. Collateral and Compensating Balances5. Credit rationing
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Screening and the problem of Adverse Selection Screening and the problem of Adverse Selection in loan marketin loan market::
When bad credit risk (most likely to default) are the ones who try to get loans.
Investors with risky assets are the most eager to obtain loans, but are the least desirable borrowers.
Must collect information about potential borrowers.
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Moral Hazard in loan marketMoral Hazard in loan market:: borrowers may engage in undesirable
activities from the lender’s point of view.
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Managing Interest-Rate Risk
High volatility in interest rates makes banks exposed to interest- rate risk:
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 millionpayments 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
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
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
