Ch 9: General Principles of Bank Management How the bank manages its assets and liabilities to earn the highest possible profits? The manager of the bank has 4 primary concerns: Liquidity management. Asset management. Liability management. Capital adequacy management. Liquidity management and the role of reserve:  How the bank deals with deposit outflows?  This is when deposits are lost because depositors make withdrawals and demand payment. 

Example: - RRR (10%), Bank ONE initial balance sheet: Assets Liabilities Reserves (RR=10,ER=10)  20 Deposits 100 Loans          80 Capital 10 Securities 10 The required reserve is (10), but total reserves = (20), therefore, the bank has excess reserves = (10)

If a deposit outflow of (10) occurs, the bank’s balance sheet becomes: Assets Liabilities Reserves (RR=9,ER=1) 10 Deposits 90 Loans         80 Capital 10 Securities   10

The bank loses (10) of deposits AND (10) of reserves. But since the total amount of deposits = (90), and RRR = (10%), Required reserve = (9), and Excess reserve =(1) If the bank has excess reserves, a deposits= outflow does not necessitate changes in other parts of its balance sheet.

But what if the bank holds insufficient excess reserves? Example: The bank holds no excess reserves:  Bank ONE Assets Liabilities RR   10 Deposits 100 Loans     90 capital 10 Securities 10 The required reserve is (10), and total reserves = (10), therefore, the bank holds no excess reserves = ER = (0)

If (10) deposit outflow occurs: Assets Liabilities RR    -9 Deposits 90 Loans       90 Capital 10 Securities 10 There is a decline in deposits and reserves by (10) The reserves = (0), this is a problem since the required reserve must = (9: 10%×90) The bank has NO RESERVE!

Pays interest = Federal Fund Rate To eliminate this problem, the bank has 4 options:  1. Borrowing from other banks (FED), or borrowing from corporation. The bank’s balance sheet becomes: Assets Liabilities Reserves   9 Deposits 90 Loans       90 Borrowing from other banks or corp. 9 Securities 10 Capital 10 Pays interest = Federal Fund Rate

Cost= Liquidation, brokerage… 2. Sell securities: Sell securities worth (9), the balance sheet becomes: Assets Liabilities Reserves    9 Deposits       90 Loans        90 Capital    10 Securities   1 Cost= Liquidation, brokerage…

Pays interest = Discount rate. 3. Borrowing from the Fed: Assets Liabilities Reserves      9 Deposits 90 Loans         90 Discount loans from the Fed 10 Securities   10 Capital                          10 Pays interest = Discount rate.

4. Calling in or selling loans: Reducing its loans by (9) and depositing the (9): Assets Liabilities Reserves         9 Deposits        90 Loans            81 Capital          10  Securities      10   This solution is costly: May not be able to renew loans of some clients Sell loans at lower values

This shows why a bank holds excess reserves though reserves pay no interest: to face deposits outflow. Excess reserves are insurance against the cost associated with deposits outflows. The higher the costs associated with deposit outflows, the more excess reserves bank will want to hold.

2. Asset Management When managing its assets (to maximize profits), the bank must: A  Seek the highest returns on loans and securities, B  Reduce risk, C Enough provisions for liquidity (holding liquid assets).

To accomplish these goals, four basic ways: 1- Find borrowers who will pay high interest rates but unlikely to default (Screening to reduce adverse selection problem). 2- Purchase securities with high returns and low risk. 3- Diversification of assets: purchase different type of assets, diversify borrowers. 4- Manage liquidity to satisfy reserves requirements.

3- Liability Management The use of liabilities in the creation of reserves and liquidity (Assets): Before: No interest paid on checkable deposits, therefore, no competition for deposits between banks. Banks rarely used overnight loans

After: Expansion of overnight loans Development of new financial instruments The flexibility in liability management means: the bank need not to depend on checkable deposits as the primary source of funds (liabilities). 

4- Capital Adequacy Management Capital= Bank’s net worth = Total assets – Total liabilities Maintaining the appropriate capital (net worth) to prevent bank failure, maintain owners’ returns, and meet central bank regulations.

1- Prevent Bank Failure:  Example (1): Consider two banks, one with capital to assets ratio of 10% and the other with 4%.  High Capital Bank Assets Liabilities  Reserves          10  Deposits           90  Loans             90    Bank Capital    10 Low Capital Bank Assets Liabilities  Reserves           10 Deposits            96  Loans               90  Bank Capital      4  If the two banks lose % 5 million of their loans, their assets and capital will decline too by the same amount.

The new balance sheets become as follows:   High Capital Bank Assets Liabilities  Reserves      10  Deposits           90  Loans          85  Bank Capital      5   Low Capital Bank Reserves     10  Deposits              96  Loans         85  Bank Capital        -1    The high capital bank is still in a good situation because its net worth (capital) is still positive ($5 million).

The low capital bank is in a bad situation because its net worth is negative (-$1 million)  The value of its assets is less than its liabilities, therefore it is insolvent (bankrupt): It does not have enough assets to pay off holders of its liabilities (creditors). When a bank becomes insolvent, the government closes it.

2- Bank Capital Affects Returns to Equity Holders:  Bank owners need measures of bank profitability to know if the bank is managed well or not: A. Return on Assets (ROA): ROA = Net profit after taxes / Assets The ROA shows how efficiently a bank is being run by indicating how much profits are generated on average by each dollar of assets.

B. Return on Equity (ROE): ROE = net profit after taxes / equity capital The ROE shows how much the bank earns on equity investment.

 C. Equity Multiplier (EM): EM = assets / equity capital It is the amount of assets per dollar of equity capital. It shows the direct relationship between ROA and ROE: Net profit after taxes / Equity capital = (net profit after taxes / assets) X (assets / equity capital) ROE = (ROA) X (EM)

ROE = (ROA) X (EM) This formula show what happens to the return on equity when a bank holds a smaller amount of capital (equity) for a given amount of assets.

Example The high capital bank has an EM = 10 (100 / 10) = 10 The low capital bank has an EM = 25 (100 / 4) = 25 If ROA is 1%, then: ROE for the high capital bank = 1% X 10 = 10% ROE for the low capital bank = 1% X 25= 25%

Equity holders of the low capital bank are happier because they have a return twice higher. Thus, bank owners don't like holding a lot of capital (because it reduces ROE(

Result: Given the ROA, the lower the bank capital, the higher the ROE Result: Given the ROA, the lower the bank capital, the higher the ROE. This show that there is a trade-off between safety and returns. Tradeoff: High bank capital reduces possibility of bankruptcy, but lowers (ROE)

3- Bank Capital Requirements:  Banks hold capital because they are required by law to do so.

 Managing Credit Risk The bank must make good loans that are paid back (No default) Screening and Monitoring, Long-Term Customer Relation Loan commitments Collateral and Compensating Balances Credit rationing

Screening and the problem of Adverse Selection in loan market: When bad credit risk (most likely to default) are the ones who try to get loans. Investors with risky assets are the most eager to obtain loans, but are the least desirable borrowers. Must collect information about potential borrowers.

Moral Hazard in loan market: borrowers may engage in undesirable activities from the lender’s point of view.

Managing Interest-Rate Risk High volatility in interest rates makes banks exposed to interest- rate risk: The risk of earnings and returns that is associated with changes in interest rates.

 Example: First National Bank Assets Liabilities  Rate-sensitive Assets   Rate-sensitive Liabilities  Fixed -rate Assets  Fixed-rate Liabilities $ 20 million of assets are rate sensitive, while $80 million with fixed rates. $ 50 million of liabilities are rate sensitive, while $ 50 million with fixed rates.

If interest rate rises from 10% to 15% (∆ 5%): income on assets rises by $1 million: ∆ in income = ∆ in interest  X rate sensitive assets                  = 5%  X $ 20 million  =  $ 1 million payments on liabilities rise by $2.5 million: ∆ in cost of liabilities = ∆ in interest  X rate sensitive liabilities =5%  X $ 50 million  =  $ 2.5 million The bank profit's decline by $1.5 million ($1 - $2.5)

However, if interest rate falls by 5%, profit rises by $1.5 million. Result: If a bank has more rate-sensitive liabilities than assets, a rise in interest rates reduces bank profits, while a decline in interest rates raises profits.

Gap and Duration Analysis: 1- Gap Analysis: The sensitivity of bank profits to changes in interest rates can be measured directly using gap analysis by: (Rate sensitive Assets - Rate sensitive liabilities) In the example above, the gap equals $30 million ($20 - $50)

By multiplying the change in interest rate by the gap, we obtain the effect on profits: ∆ in profit = 5%  X  - $30 million = - $1.5 million.

2- Duration Analysis An alternative measure of interest rate risk is duration analysis, which examines the sensitivity of the market value of the bank's total assets and liabilities to changes in interest rates.

Duration analysis uses the average duration of assets and liabilities to see how the net worth responds to a change in interest rates.

(- % ∆ in interest rate x Duration) To measure the effect of bank's net worth due to a change in interest rate: %∆ in market value= (- % ∆ in interest rate x Duration)   Do the same so A-L

In the example above, if average duration of assets is three years and liabilities is two years, assets are $100 million, and liabilities are $90 million.

If interest rate rises by 5%: Value of assets falls by 15% (- 5% X 3 years)-, or $15 million. Value of liabilities falls by 10% (-5%  X  2 years), or $9 million. Or: (-5% X 3 X 100) - (-5% X 2 X 9) = -15 + 9 = -6!

Net worth falls by $ 6 million, or 6% of assets. However, a 5% decline in interest rates increases net worth by 6% (of total assets) Can you show how?

Off-Balance-Sheet Activities This involve activities that affect bank profits, but do not appear on the bank’s balance sheet. Trading financial instruments and generating income from fees and loan sales.

1- Loan Sales (Secondary Loan Participation): A contract that sells all or part of the cash stream of a loan therefore, it removes the loan from the bank’s balance sheet. 2- Generation of Fee Income: Earned from providing specialized services to customers: foreign exchange trade, mortgage backed security, banker’s acceptance…

3- Trading Activities and Risk management Techniques: International Banking Trading in financial markets Speculations Risky activities: Insolvency.