1. Money & Banking Maclachlan, Spring 2006 1 Management of Financial Institutions Chapter 9

2. Money & Banking Maclachlan, Spring 2006 2 Bank Balance Sheet Assets (Uses of Funds)Liabilities (Sources of Funds) Reserves 5 Securities 25 Loans 64 Other assets 6 Checkable deposits 9 Non-trans. Deposits 56 Borrowings 28 Bank Capital 7

3. Money & Banking Maclachlan, Spring 2006 3 Indirect Finance vs. Direct Finance Commercial banks Commercial banks make profits through asset transformation (borrow short, lend long). Investment Banks Investment banks make profits through acting as brokers of securities.

4. Money & Banking Maclachlan, Spring 2006 4 General Principles of Bank Management 1.Liquidity Management 2.Asset Management 3.Liabilitity Management 4.Capital Adequacy Management

5. Money & Banking Maclachlan, Spring 2006 5 Two Types of Risk Credit Risk Interest Rate Risk

6. Money & Banking Maclachlan, Spring 2006 6 Managing Risk “The business of banking is the production of information.” -- Walter Wriston, former head of Citicorp

7. Money & Banking Maclachlan, Spring 2006 7 Credit Risk Asymmetric information. Before transaction: adverse selection. After transaction: moral hazard.

8. Money & Banking Maclachlan, Spring 2006 8 Methods to deal with Credit Risk Screening Monitoring Relationship banking Loan commitments Collateral Credit rationing

9. Money & Banking Maclachlan, Spring 2006 9 Interest Rate Risk Risk associated with borrowing short and lending long. If interest rates rise, liabilities will be turned over at new higher rates while the bank is still earning low rates on assets.

10. Money & Banking Maclachlan, Spring 2006 10 Managing Interest Rate Risk Keep track of the gap = rate sensitive assets – rate sensitive liabilities Loan sales Fee income Derivatives (financial contracts as insurance)

11. Money & Banking Maclachlan, Spring 2006 11 Calculate the 1-year GAP (RSA-RSL) Assets (in millions)Liabilities (in millions) Reserves 50 Treasury bonds 200 ARM’s 300 Fixed rate mortages 150 Three year car loans 50 Two year fixed rate business loans 90 Floating rate business loans 100 Other assets 60 Borrowed Fed funds 10 Checkable deposits 90 3 month CDs 160 6 month CDs 200 9 month CDs 200 Corporate bonds 270 Bank Capital 70 (300+100)-(10+90+160+200+200) = -260