1. Commercial Bank Management
Program MM Banking
STIE Perbanas
Lecture Notes
Commercial Bank Management

2. Total assets = total liabilities + capital
Bank balance sheet
Total assets = total liabilities + capital
Source of funds (liabilities):
Deposits (demand, savings and time) – third party funds (Dana Pihak Ketiga/DPK)
Borrowed funds, subordinated notes and bonds
Capital
Bank uses of funds (assets):
Cash assets – vault cash, reserve at central bank, balance on other banks
Federal funds sold dan reverse repo
Investments – government bonds/securities
Loans and leases

3. Bank balance sheet Source of funds Deposits Borrowed funds
Deposits are the principal source of funds
Demand deposits
Checking/ giro account – owners entitled to write checks or giro
Savings deposits/accounts
Money market deposit accounts
Time deposits
Certificates of deposits
Negotiable certificate of deposits (NCD)
Borrowed funds
USA
Federal funds – o/n interbank call money
Repos
Banker’s acceptance
Federal Reserve Bank loans – short term (15 days)
Indonesia
Interbank call money (Pasar Uang Antar Bank/PUAB)
BLBI (but no longer since UU 23/1999)

4. Bank balance sheet Source of funds
The bulk of commercial bank funds - about two-thirds of the total – comes from deposits
Principal nondeposits sources of funds for banks include purchases of reserves from other banks, securities repurchace agreements, and the issuance of capital notes.
Recently banks have turned to new nondeposit funds sources, including floating-rate CDs and notes sold international markets, sales of loans, securitization of selected assets.
Equity capital (or networth) applied by a bank’s stockholders provides only a minor portion of (around 10% on average, but at least 8% according Basle II) total funds for most banks today.

5. Bank balance sheet Source of funds
Securitizations of bank loans to raise funds
Some loans removed
From balance sheet, pooled,
and placed under the control of
separate corporation or trust
Securities are issued
against the pool of
loans and sold to
capital market
Bank
loans
Proceeds of security sales flow back to the bank as
a new sorce of funds

6. Bank balance sheet Uses of funds
Cash assets – vault cash, reserve or deposit at central bank, balance on other banks
Required reserves
Excess reserves
Investment
Government bonds/bills
Local government securities
Central bank bills (SBI in Indonesia)
Loans and leases
Loans are primary bussiness of commercial banks
Loand are the most profitable but subject to greater default risk
May be secured (with collateral) or unsecured
Fixed rate or floating rate loans
Types of loans: commercial and industrial loans, interbank loans, real estate loans, agricultural loans, consumer loans (loans to individuals, e.g. credit card)
Lease financing

7. Bank balance sheet Uses of funds
Cash (primary reserves) is the banker’s first line of defense againts withdrawals by deposits and customer demand for loans
Commercial banks hold securites (mostly short-term) acquired in the open market as an investment and as a secondary reserves to help meet short-term cash needs.
Loans are among the highest yielding assets a bank can add to its portfolio, and they often provide the largest portion of traditional banks’ operating revenue.

8. Bank balance sheet Uses of funds Loans pricing
Subject to risk assessment
The prime rate – benchmark or base rate (charged to the most creditworthy customers)
Base rate loan pricing
r = BR + DR + TM + CF
r = individual customer loan rate
BR = the base rate
DR = adjustment for default risk above base rate customer
TM = adjustment for term to maturity
CF = competitive factor
Cost of loanable fund

9. Basic Operation of a Bank
Asset transformation
transforming deposits into loans
“borrows short and lends long”
Providing payments services
T-account (simplified balance sheet) presentation:
Suppose Melisa opens an checking account at Lippo bank with Rp 100 million cash (banknotes)
Felix opens at the same bank with Rp 100 million check written on her account at BCA.
Lippo Bank
Assets
Liabilities
Reserves
Vault cash
Cash in the process of
collection
Checkable dep
Melisa
Felix

10. Basic operation of a bank
After collection (through check clearing process - interbank), T-acc of the two banks:
Lippo Bank
Assets
Liabilities
Reserves
Vault cash
Giro acct at Central bank
Checkable dep
Melisa
Felix
BCA
Assets
Liabilities
Reserves
Giro acc at Central bank
Checkable dep
Felix
When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves

11. Basic operation of a bank
What next Lippo Bank is going to do with additional reserves of Rp 200 million?
Suppose the required reserves (imposed by the central bank) is 10%, there will be 90% of excess reserves available to lend.
Lippo Bank
Assets
Liabilities
Reserves
Required reserves
Excess reserves
Checkable dep
Melisa
Felix
Assets
Liabilities
Reserves
Required reserves
Excess reserves
- 180
Loans
Checkable dep
Melisa
Felix

12. Basic operation of a bank:
Deposits or Money creation
Let assume the debtor receiving Rp180 million from Lippo Bank put the money back at her account at the same bank; deposits at Lippo bank will increase by the same amount, the loan operation will continue.
Lippo Bank
Assets
Liabilities
Reserves
Required reserves
10% *
10% *
Excess reserves
- 180
+ 162
.Loans
to PT X
to PT Y
Checkable dep
Melisa
Felix
PT X
PT Y

13. Basic operation of a bank: Deposits or Money creation
Banks have the power to create money in the form of new checkable deposits, credit card lines, debit cards, and other immediately spendable funds.
The banking system as a whole can create a volume of money equal to a multiple of any excess reserves deposits with it simply by making loans and purchasing securities.
Each bank reserves may divided into 2 categories:
Required reserves
Excess reserves
The distinction between excess and required reserves is important because it plays a key role in the growth of credit in the economy and the creation of money in the banking system.
When all excess reserves extended (making loans), the banking system is called “loaned-up”.

14. General Principle of Bank Management
Liquidity management
Make sure enough cash to meet deposit withdrawal
Too much cash is costly
Assets management
Acquiring assets with low risk
Diversifying assets holdings
Liability management
Acquiring funds with low cost
Capital management
Maintain capital adequacy

15. Liquidity management Either fail to meet deposit withdrawal
Banks need to maintain adequate reserves to meet deposit withdrawal and reserve requirement
If a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.
What if a bank holds insufficient reserves?
Either fail to meet deposit withdrawal
Or fail to meet required reserves  penalty
What that bank will do?
it can either borrow from other banks (fed funds in US and PUAB in Indonesia),
or sell securities (T-bills/bonds),
or borrow from the central bank (discount rates).

16. Liquidity management
 With 10% reserve requirement, bank still has excess reserves of Rp 1 million: no changes needed in balance sheet
17-16

17. Liquidity management
 With 10% reserve requirement, bank has Rp 9 million reserve shortfall

18. Liquidity management
What the bank will do?

19. Liquidity management
 Excess reserves are insurance against above 4 costs from deposit outflows;
Banks hold excess reserves even though loans or securities earn a higher return.
(Empirical evidence in Indonesia, RR=5%, average ER= 2%)
17-19

20. Assets management
Maximizing profits by seeking the highest returns possible for loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets
Four ways in accomplishing these three goals:
Find borrowers who will pay high interest rates and unlikely to default – the role of bank’s loan officers.
Purchase securities with high returns and low risk.
Diversifying assets portfolio (short, long-term) to lower risk – “do not put your eggs into one basket”.
Manage liquidity of the assets, easy to get cash to meet reserve requirement – how much excess reserves must be held to avoid cost from a deposit outflow.

21. Liability management
Managing the source of funds, from deposits, to CDs, to other debt – banks no longer depends primarily deposits - When see loan opportunities, borrow or issue CDs to acquire funds
So a bank can target goals for their assets growth and acquire funds by issuing liabilities in the money market or by borrowing from another bank (interbank money market – o/n federal funds in the US market).
Flexibility in the liability management and the search for higher profits have stimulated banks to increase proportion of loans (which earn higher income) in their total assets.

22. Capital management
Bank capital is a cushion that prevents bank failure, in case the bank cannot satisfy its obligation to pay its depositors or creditors
The higher is bank capital, the lower is return on equity
ROA = Net Profits/Assets
ROE = Net Profits/Equity Capital
EM (Equity multiplier) = Assets/Equity Capital
ROE = ROA  EM
Capital , EM , ROE 

23. Capital management Tradeoff between safety (high capital) and ROE
Banks also hold capital to meet capital adequacy requirements imposed by authorities
Strategies for Managing Capital
Sell or retire stock
Change dividends to change retained earnings
Change asset growth

24. Off-balance sheet activities
In today’s more competitive environment, off-balance sheet activities have grown to be a source of bank’s profit – activities that affect bank profits but do not appear on the bank balance sheets.
Off-balance activities generate income:
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
Payments services on behalf of customers – low risk

25. Measuring Bank Performance
Four dimensions of bank performance today:
The bank’s market value or stock price
The bank’s rate of return or profitability ratios
The bank’s risk exposure
The bank’s operating efficiency.
Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts:
Operating Income
Operating Expenses
Net Operating Income
Note how this is different from, say, a manufacturing firm’s income statement.

26. Banks' Income Statement

27. Bank’s income statement & Balance sheet Bank Central Asia
Profit & Loss Statement
Balance sheet
Year to 31 Dec 2006
(Rp trio)
Average earning assets
Net interest margin
Net interest income
Fees and commissions
Other income
Total operating income
Operating expenses
Preprovision profit
Loan loss provision
Pretax profit
Tax
Net profit
Average shares (million)
EPS (rp)
DPS (rp)
Divident payout ratio
148.40
6.1%
9.03
2.03
0.60
11.65
5.11
6.53
(0.60)
6.00
(1.82)
4.24
12.32
0.34
0.15
50%
At 31 Dec 2006
(Rp trio)
Assets
Cash on hand
Deposits at BI
Placements
Market securities
Government bonds
Net loans
Fixed assets
Other
Total assets
Liabilities
Customer deposits
Borrowings
Other liabilities
Total liabilities
Equity
Total liabilities & equity
5.49
19.17
6.30
28.27
49.14
59.69
2.21
3.26
176.80
153.76
0.74
2.64
158.73
18.07

28. Selected banking performance indicators
Capital adequacy ratio (CAR) – capital/risk weighted assets
Earning assets quality ratio – classified earning assets/total earning assets
Return on assets ratio – annual profit before taxes/average assets
Operations expenses to operations income ratio
Liquid asset to liquid liabilities ratio
Loan to deposit ratio (LDR) – total credit/third party funds (deposits)
Non-performing loan ratio (NPL) – credits that are sub-standard,dubtful and loss/ total credits
Net interest margin (NIM) ratio –net interest income/average earning assets
Note: See Indonesian Banking Statistics (Bank Indonesia monthly publication)

29. Recent Trends in Bank Performance Measures
As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows historical averages for key bank performance measures in US.
ROA = Net Profits/ Assets
ROE = Net Profits/ Equity Capital
NIM = [Interest Income - Interest Expenses]/ Assets