1. Chapter 9: Bank Management
Chapter Objectives
Explain what a balance sheet and a T-account are.
Explain what banks do in five words and also at length.
Describe how bankers manage their banks’ balance sheets.
Explain why regulators mandate minimum reserve and capital ratios.
Describe how bankers manage credit risk.
Describe how bankers manage interest rate risk.
Describe off-balance sheet activities and explain their importance.

2. 1. The Balance Sheet
Chapter Objectives
Explain what a balance sheet and a T-account are.
What is a balance sheet and what are the major types of bank assets and liabilities?

3. 1. The Balance Sheet
Liabilities – money that companies borrow in order to buy assets
Equity (Net Worth or Capital) – residual that makes the two sides of the equation balance (banks have little)
A company is economically viable if what it owns exceeds the value of what it owes (Equity is positive)
A company is not economically viable if the value of what it owes exceeds the value of what it owns. (Equity is negative)
The value of assets and liabilities (equity) fluctuates due to changes in interest rates and asset prices

4. 1. The Balance Sheet
For banks
Reserves: In this context, cash funds that bankers maintain to meet deposit outflows and other payments
Required reserves: A minimum amount of cash funds that banks are required by regulators to hold
Secondary reserves: Noncash, liquid assets, like government bonds, that bankers can quickly sell to obtain cash

5. Assets Commercial banks own Reserves of cash and deposits with the Fed
Secondary reserves of government and other liquid securities
Loans to businesses, consumers, and other banks
Other assets, including buildings, computer systems, and other physical stuff

6. Liabilities
The right-hand side of the balance sheet lists a bank’s liabilities or the sources of its fund
Deposits:
Transaction deposits: negotiable order of withdrawal accounts and money market deposit accounts
Non-transaction deposits: savings, negotiable certificates of deposit
Time deposits

7. Liabilities Bank Holding Company
A corporate entity than owns one or more banks and banking-related subsidiaries
Bank Holding Company

8. The easiest way to analyze this dynamism is via so-called T-accounts
Asset transformation and balance sheets provide us with only a snapshot view of a financial intermediary’s business
Intermediaries, like banks, are dynamic places where changes constantly occur
The easiest way to analyze this dynamism is via so-called T-accounts
Simplified balance sheets that list only changes in liabilities and assets

9. 3. Bank Management Principles
Chapter Objectives
Describe how bankers manage their banks’ balance sheets.
Explain why regulators mandate minimum reserve and capital ratios.
What are the major problems facing bank managers and why is bank management closely regulated?

10. Bank management risks
While earning profits and managing liquidity and capital, banks face two major risks:
Credit risk - The risk of borrowers defaulting on the loans and securities it owns
Interest rate risk - The risk that interest rate changes will decrease the returns on its assets and/or increase the cost of its liabilities

11. 3. Bank Management Principles Liquidity management
Net deposit outflow (inflow)  Reserve ratio decreases (increase) Increase (decrease) reserves in the cheapest way possible
Sell (buy) assets
high transaction costs
Sell (extend) loans
adverse selection
Sell (buy) securities
Call in (extend) loans
high opportunity costs
Increase (decrease) deposits
high transaction costs and added operating costs
Borrow from discount window (Fed)
Borrow from (lend to) Fed Funds (other banks)

12. 3. Bank Management Principles Asset management
Entails the usual trade-off between risk and return
Bankers should diversify, make loans to a variety of different types of borrowers,
Preferably in different geographic regions
Bankers need secondary reserves, some assets that can be quickly and cheaply sold to bolster reserves if need be

13. 4. Credit Risk
No matter how good bankers are at asset, liability, and capital adequacy management, they will be failures if they cannot manage credit risk.
Managing credit risk  managing
Asymmetric information
Adverse selection
Moral hazard

14. Managing asymmetric information
4. Credit Risk
Managing asymmetric information
Screening create information/reduce asymmetry
reduce adverse selection embed information in binding contract
third-party verification
Specialization maximize efficiency of screening
Increase efficiency create exposure to systemic risk
Long-term loan commitments (line of credit)
reduce moral hazard other business services

15. Managing asymmetric information
4. Credit Risk
Managing asymmetric information
Securitize collateral
reduce moral hazard compensatory balances
loan covenants
Credit rationing no credit at any interest rate
reduce adverse selection limit credit
reduce moral hazard

16. 5. Interest-Rate Risk
Financial intermediaries are exposed to interest rate risk because their assets and liabilities are exposed to interest rate risk.
Interest rate risk is determined by the value of risk-sensitive assets, the value of risk-sensitive liabilities, and the change in interest rates.

17. 6. Off the Balance Sheet
Chapter Objectives
Describe off-balance sheet activities and explain their importance.
What are off-balance-sheet activities and why do bankers engage in them?

18. 6. Off the Balance Sheet
Banks and other financial intermediaries take off-balance-sheet positions in derivatives markets, including futures and interest rate swaps
Use derivatives to hedge their risks
Try to earn income should the bank’s main business suffer a decline if, say, interest rates rise
Hedge their interest rate risk by engaging in interest rate swaps
Speculate in derivatives and the foreign exchange markets, hoping to make a big killing

19. The 2008 Crisis: Credit default swaps
6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
“Credit default swaps, which were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised.
Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.”
The New York Times, as quoted in Times Topics

20. The 2008 Crisis: Credit default swaps
6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
“The market for the credit default swaps has been enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.
Also in sharp contrast to traditional insurance, the swaps are totally unregulated.…
The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late ”
Michael Lewitt, September 16, 2008, The New York Times, as quoted in Times Topics