Copyright © 2009 Pearson Prentice Hall. All rights reserved General Principles of Bank Management Now let’s look at how a bank manages its assets and liabilities. The bank has four primary concerns: 1.Liquidity management 2.Asset management 3.Liability management 4.Managing capital adequacy

Copyright © 2009 Pearson Prentice Hall. All rights reserved Asset Management Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk. 1.Get borrowers with low default risk, paying high interest rates 2.Buy securities with high return, low risk …Diversify (banks must attempt to lower risk by diversifying): not “put too many eggs in one basket”

Copyright © 2009 Pearson Prentice Hall. All rights reserved Liability Management Liability Management: managing the source of funds, from deposits, to CDs, to other debt. 1.Markets for making overnight loans between banks to meet reserve needs 2.When see loan opportunities, borrow or issue securities to acquire funds 3.Costs vs. stability 4.Reduced borrowings: credit crunch

Copyright © 2009 Pearson Prentice Hall. All rights reserved Liability Management It’s important to understand that banks now manage both sides of the balance sheet together, whereas it was more separate in the past. Indeed, most banks now manage this via the asset-liability management (ALM) committee.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Capital Adequacy Management 1.Bank capital is a cushion that prevents bank failure. For example, consider these two banks:

Copyright © 2009 Pearson Prentice Hall. All rights reserved Capital Adequacy Management What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let’s assume both banks lose $5 million from bad loans.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Capital Adequacy Management Impact of $5 million loan loss Conclusion: A bank maintains reserves to lessen the chance that it will become insolvent.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Capital Adequacy Management So, why don’t banks want to hold a lot of capital?? 2.Higher is bank capital, lower is return on equity (the net profit after taxes per dollar of equity capital) – ROE = Net Profits/Equity Capital – Capital , ROE 

Copyright © 2009 Pearson Prentice Hall. All rights reserved Capital Adequacy Management 3.Trade-off between safety (high capital) and ROE 4.Banks also hold capital to meet capital requirements: if bank managers want to hold less bank capital relative to assets than is required by the regulatory authorities, the amount of bank capital is determined by the bank capital requirements

Measuring Bank Performance Ratio analysis is useful to measure performance and compare performance among banks. In order to measure ratios, we need to reclassify the bank’s balance sheet Copyright © 2009 Pearson Prentice Hall. All rights reserved

Measuring Bank Performance AssetsLiabilities Interest-earning assetsInterest-costing liabilities Non interest-earning assetsNon interest-costing liabilities Real estate assetsBank capital Total assetsTotal liabilities Working capital = interest earning assets – interest costing liabilities Copyright © 2009 Pearson Prentice Hall. All rights reserved

Copyright © 2009 Pearson Prentice Hall. All rights reserved Measuring Bank Performance Much like any business, measuring bank performance requires a look at the income statement. For banks, this is different from, say, a manufacturing firm’s income statement.

Income statement INCOME STATEMENT Interest income - interest expenses = Net Interest profits + Noninterest income (fees and gains/losses on securities) = Profits from Intermediation - Operating costs = Net operating profits +/- Extraordinary items - Income taxes = Net profits (Profits after taxes) Copyright © 2009 Pearson Prentice Hall. All rights reserved

Measuring Bank Performance ROE = Net Profits/ Equity Capital Operating ROE = Net Operating Profits / Equity Capital Operating ROE = NOP/EC = NIP/EC * PI/NIP * NOP/PI Copyright © 2009 Pearson Prentice Hall. All rights reserved

Measuring Bank Performance Interest ROE = NIP/EC NIP/EC = (Interest income / Interest- earning assets) * (Working capital / EC) + (Interest income / Interest-earning assets – Interest expenses / Interest-costing liabilities) * (Interest-costing liabilities/EC) Copyright © 2009 Pearson Prentice Hall. All rights reserved