1. Copyright  2011 Pearson Canada Inc. 13 - 1 Chapter 13 Banking and the Management of Financial Institutions

2. Copyright  2011 Pearson Canada Inc. 13 - 2 Assets Cash reserves Deposits at Other Banks Cash Items in Process of Collection Securities Loans Fixed and Other Assets

3. Copyright  2011 Pearson Canada Inc. 13 - 3 Liabilities I Demand and Notice Deposits Fixed – Term Deposits Borrowings –Overdraft loans (advances) –Settlement balances Bank capital Reserves –Vault cash –Desired reserves –Banker’s risk –Desired reserve ratio

4. Copyright  2011 Pearson Canada Inc. 13 - 4 Liabilities II Cash Items in Process of Collection –Items in transit (bank float) Deposits at Other Banks –Interbank deposits Securities –Secondary reserves Loans Other Assets

5. Copyright  2011 Pearson Canada Inc. 13 - 5 The Bank Balance Sheet

6. Copyright  2011 Pearson Canada Inc. 13 - 6 Basic Banking I Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in chequable deposits First BankBusiness AssetsLiabilitiesAssetsLiabilities Loans+$100Chequable deposits +$100Chequable Deposits +$100Bank Loans+$100 First bank makes a loan of $100 to a business and credits the business's chequable deposit.

7. Copyright  2011 Pearson Canada Inc. 13 - 7 Basic Banking II First BankSecond Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves-$100Chequable deposits -$100 First Bank AssetsLiabilities Cash items in process of collection +$100Chequable deposits +$100 When a bank receives additional deposits, it gains an equal amount of reserves: when it loses deposits, it loses an equal amount of reserves

8. Copyright  2011 Pearson Canada Inc. 13 - 8 Basic Banking—Making a Profit Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long First Bank AssetsLiabilitiesAssetsLiabilities Desired reserves +$100Chequable deposits +$100Desired reserves +$10Chequable deposits +$100 Excess reserves +$90Loans+$90

9. Copyright  2011 Pearson Canada Inc. 13 - 9 Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

10. Copyright  2011 Pearson Canada Inc. 13 - 10 Liquidity Management and the Role of Reserves If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital$10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓

11. Copyright  2011 Pearson Canada Inc. 13 - 11 Liquidity Management: Shortfall in Reserves Reserves are now short of the desired amount and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital$10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓

12. Copyright  2011 Pearson Canada Inc. 13 - 12 Liquidity Management: Borrowing Cost incurred is the interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M Borrowing $9 million from other banks

13. Copyright  2011 Pearson Canada Inc. 13 - 13 Liquidity Management: Securities Sale The cost of selling securities is the brokerage and other transaction costs AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M Can meet shortfall by reducing loans by $9 million

14. Copyright  2011 Pearson Canada Inc. 13 - 14 Liquidity Management: Bank of Canada Advances Borrowing from the Bank of Canada also incurs interest payments based on the discount rate AssetsLiabilities Reserves$9MDeposits$90M Loans$90MAdvance Bank of Canada $9M Securities$10MBank Capital$10M Borrow $9 million from the Bank of Canada

15. Copyright  2011 Pearson Canada Inc. 13 - 15 Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

16. Copyright  2011 Pearson Canada Inc. 13 - 16 Asset Management: Three Goals Seek the highest possible returns on loans and securities Reduce risk Have adequate liquidity

17. Copyright  2011 Pearson Canada Inc. 13 - 17 Asset Management: Four Tools Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets

18. Copyright  2011 Pearson Canada Inc. 13 - 18 Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

19. Copyright  2011 Pearson Canada Inc. 13 - 19 Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement

20. Copyright  2011 Pearson Canada Inc. 13 - 20 Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

21. Copyright  2011 Pearson Canada Inc. 13 - 21 Capital Adequacy Management: Returns to Equity Holders

22. Copyright  2011 Pearson Canada Inc. 13 - 22 Capital Adequacy Management: Safety Benefits the owners of a bank by making their investment safe 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 Bank capital requirement

23. Basel I, II and III Most standardized and widely accepted/required Capital Adequacy Requirement It is made by the Bank for International Settlement in Swiss. Started with Basel I in 1988; has moved to Basel II(current) now; and will move to Basel III. http://www.bis.org/publ/bcbs128.htm Copyright  2011 Pearson Canada Inc. 13 - 23

24. Calculating the Capital Adequacy Ratio within Basel Accord http://en.wikipedia.org/wiki/Capital_adequacy_ratio Formula Capital adequacy ratio ("CAR") is a measure of the amount of a bank's core capital expressed as a percentage of its assets weighted credit exposures.core capitalassetscredit Capital adequacy ratio is defined as TIER 1 CAPITAL -A)Equity Capital, B) Disclosed Reserves TIER 2 CAPITAL -A)Undisclosed Reserves, B)General Loss reserves, C)Subordinate Term Debts where Risk can either be weighted assets (0 to 1)Risk ≥ 10%. Copyright  2011 Pearson Canada Inc. 13 - 24

25. Copyright  2011 Pearson Canada Inc. 13 - 25 Strategies for Managing Bank Capital Lowering Bank Capital: Buying back some of Bank’s stock Pay out higher dividend to shareholders Acquire new funds and increase assets Raising Bank Capital: Issue more common stock Reducing dividend to shareholders Issue fewer loans or sell securities and use proceeds to reduce liabilities

26. Copyright  2011 Pearson Canada Inc. 13 - 26 Managing Credit Risk I A major component of many financial institutions business is making loans To make profits, these firms must make successful loans that are paid back in full The concepts of moral hazard and adverse selection are useful in explaining the risks faced when making loans

27. Copyright  2011 Pearson Canada Inc. 13 - 27 Managing Credit Risk II Adverse selection is a problem in loan markets because bad credit risks (those likely to default) are the one which usually line up for loans Those who are most likely to produce an adverse outcome are the most likely to be selected

28. Copyright  2011 Pearson Canada Inc. 13 - 28 Managing Credit Risk III Moral hazard is a problem in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful The high risk, however, makes it less likely the loan will be repaid.

29. Copyright  2011 Pearson Canada Inc. 13 - 29 Managing Credit Risk IV To be profitable, lending firms must overcome adverse selection and moral hazard problems Attempts by the lending institutions to solve the problems explains a number of principles for managing risk

30. Copyright  2011 Pearson Canada Inc. 13 - 30 Principles for Managing Credit Risk Screening and Monitoring –Screening –Specialization in Lending –Monitoring and Enforcement of Restrictive Covenants Long-term Customer relationships Loan Commitments Collateral and Compensating Balances Credit Rationing

31. Copyright  2011 Pearson Canada Inc. 13 - 31 Interest Rate Risk If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income

32. Copyright  2011 Pearson Canada Inc. 13 - 32 Gap Analysis The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive assets – rate-sensitive liabilities GAP = RSL – RSA A change in the interest rate (Δi) will change bank income (  depending on the Gap  Income = GAP   i

33. Copyright  2011 Pearson Canada Inc. 13 - 33 Owners and managers care not only about the change in interest rates on income but also on net worth of the institution Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates Duration Analysis I

34. Copyright  2011 Pearson Canada Inc. 13 - 34 %ΔP = - DUR x [Δi/(1+i)] Where: P is the market value %ΔP = (P t+1 – P t )/P DUR = duration i = interest rate Duration Analysis II

35. Copyright  2011 Pearson Canada Inc. 13 - 35 The Duration Gap can be calculated as: DUR gap = Dur a – (L/A x DUR L ) Where: Dur a = average duration of assets L = market value of liabilities A = market value of assets Dur l = average duration of liabilities Duration Analysis III

36. Copyright  2011 Pearson Canada Inc. 13 - 36 The impact of the interest rate change on net worth (NW) as a percentage of assets can be calculated via: Δ NW/A = -Dur gap x Δi/(1+i) Where: DUR gap = duration gap Δi = interest rate change i = interest rate Duration Analysis IV

37. Copyright  2011 Pearson Canada Inc. 13 - 37 Thus Δ NW/A = -Dur gap x Δi/(1+i) Δ NW/A = -1.72 x 0.01/(1+0.10) = -0.016 = -1.6% With assets = $100m, the fall in NW when the interest rises from 10% to 11% equals -1.6% of $100m = -$1.6M (found earlier) Duration Analysis V

38. Copyright  2011 Pearson Canada Inc. 13 - 38 Off-Balance-Sheet Activities I Loan sales (secondary loan participation) Generation of fee income Trading activities and risk management techniques –Futures, options, interest-rate swaps, foreign exchange –Speculation

39. Copyright  2011 Pearson Canada Inc. 13 - 39 Off-Balance-Sheet Activities II Trading activities and risk management techniques (continued) –Principal-agent problem –Internal Controls Separation of trading activities and bookkeeping Limits on exposure Value-at-risk Stress testing