2. The Banking Firm and Bank Management
Chapter Fifteen
The Banking Firm and Bank Management

3. The Bank Balance Sheet
Flow of funds (tab down to commercial banks)
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4. Bank Operation T-account Analysis:
Deposit of $100 cash into First Bank
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5. Bank Operation Deposit of $100 cheque
Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount
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6. Principles of Bank Management
Liquidity management
Asset management
Managing credit risk
Managing interest-rate risk
Liability management
Managing capital adequacy
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7. Principles of Bank Management
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8. Principles of Bank Management
With a 10% desired reserve ratio, bank still has excess reserves of $1 million: no changes needed in balance sheet
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9. Liquidity Management
With a 10% desired reserve ratio, bank has $9 million reserve shortfall
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10. Liquidity Management
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11. Liquidity Management
Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows
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12. Asset and Liability Management
Asset Management
Get borrowers with low default risk, paying high interest rates
Buy securities with high return, low risk
Diversify
Manage liquidity
Liability Management
Important since 1960s
No longer primarily depend on deposits
When see loan opportunities, borrow or issue CDs to acquire funds
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13. Capital Adequacy Management
Bank capital is a cushion that prevents bank failure
Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets
ROE = Net Profits/Equity Capital
EM = Assets/Equity Capital
ROE = ROA  EM
Capital , EM , ROE 
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14. Capital Adequacy Management (cont.)
Tradeoff between safety (high capital) and ROE
Banks also hold capital to meet capital requirements
Strategies for Managing Capital
Sell or retire stock
Change dividends to change retained earnings
Change asset growth
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15. Off-Balance-Sheet Activities
Fee income from
Foreign exchange trades for customers
Servicing mortgage-backed securities
Guarantees of debt
Backup lines of credit
Financial futures and options
Foreign exchange trading
Interest rate swaps
Loan sales
All these activities involve risk
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16. Banks' Income Statement
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17. Measures of Bank Performance
ROA = Net Profits/ Assets
ROE = Net Profits/ Equity Capital
NIM = [Interest Income - Interest Expenses]/ Assets
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18. Financial Innovation Innovation is result of search for profits
Response to Changes in Demand
Major change is huge increase in interest-rate risk starting in 1960s
Example: Variable-Rate Mortgages
Response to Changes in Supply
Major change is improvement in computer technology
Increases ability to collect information
Lowers transactions costs
Examples
Bank Credit Cards
Electronic Banking Facilities
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19. Avoidance of Existing Regulations
Regulations Behind Financial Innovation
Reserve requirements
Tax on deposits = D  rD
Deposit-rate ceilings in the United States (Reg Q)
As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings
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20. Avoidance of Existing Regulations
Examples
Eurodollars
Bank Commercial Paper
Sweep Accounts and Overnight Repos
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21. Profiting from Canada Strips
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