Presentation on theme: "Lecture 18: Bank risk management"— Presentation transcript:
1 Lecture 18: Bank risk management Mishkin Ch 9 – part Bpage
2 Outline: Liquidity Management Asset Management Liability Management enough cash and liquidity assets to pay depositorsAsset Managementdiversifying investmentLiability Managementlow cost of getting fundsCapital Adequacy Managementrequired by regulatorsmanage credit riskmanage interest-rate riskmanage risks in off-balance-sheet activities22
3 Asset managementGoal of asset managements is to seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity.Find good quality borrowersPurchase securities optimallyLower risk by diversifyingBalance need for liquidity against increased returns from less liquid assets.
4 Liability management Target: acquire funds with low costs. The old way: checkable depositsNew trend since 1960s:borrow funds in overnight loan markets (e.g. fed funds market)New financial instruments (e.g. negotiable CDs)
5 Capital adequacy management Why capital adequacy is beneficial?Bank capital is a cushion that helps prevent bank failure.Regulatory requirement.Why might banks want to hold less bank capital?The amount of capital affects return for the owners (equity holders) of the bank.
6 Prevent bank failureBank failure: a bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its reserve requirements .Holding adequate bank capital helps prevent bank failures because it can be used to absorb the losses resulting from a deposit outflow.
7 Prevent bank insolvency insolvent: liabilities > assets neg. net worthBank capital decrease the chance of insolvency.High Bank CapitalLow Bank CapitalAssetsLiabilitiesReserves$10MDeposits$90M$96MLoansBank Capital$4M$85M$5M-$1MLoan written offs
8 Returns to equity holders Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.
9 Safety – ROE tradeoff Increase bank capital is: benefit to the owners of a bank by making their investment safe (avoid bank failure).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.e.g. in more uncertain times, when the possibility of large losses on loans increases, bankers might want to hold more bank capital.
10 Managing credit riskAdverse selection and moral hazard between the bank and investors credit risk (risk that loans not paid back in full)Measures:Screening and monitoringscreening and information collectionspecialization in lendingmonitoring and enforcement of restrictive covenants
12 Interest-rate risk - example BankAssetsLiabilitiesRate-sensitive assets$20MRate-sensitive liabilities$50MFixed-rate assets$80MFixed-rate liabilities$40MInterest rate increase 5% interests earned from asset increase $1M, interest cost from liabilities increase $2.5M profit decrease $1.5MIf a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits .
14 Duration analysisDuration is the average lifetime of a security’s stream of payments.14
15 Duration analysis - example Suppose:Bank assets is $100M and liabilities is $90Mduration of bank assets is 3 yearsduration of liabilities is 2 years;Now: interest rate increase 5%,Calculate:% assets = –5% 3 = –15%% liabilities = –5% 2 = –10%assets value decrease$15M, liabilities decrease $9Mbank’s net worth decrease $6M15
16 Managing interest-rate risks GAP analysis focus on interest gain (loss) from asset and liabilities that are most sensitive to interest rate changes.Duration analysis examines the sensitivity of the market value of the bank’s total assets and liability to interest-rate changes.Need to adjust holdings of assets and liabilities to reduce interest rates risk when risks are too high.16
17 Off-balance-sheet activities Loan sales (secondary loan participation)Generation of fee incomeExamples: servicing mortgage-backed securities, guarantees of debt, etc.Trading activitiesExamples: futures market tradingPrincipal-agent problem
18 Managing risk in off-balance-sheet activities Internal controls:Separation of front and back roomsLimit risky exposureValue-at-risk modelingStress testing