MCF 304: Bank Management Lecture 2.2 Asset Management

Asset Management How to distribute bank funds among different categories of assets so as to maximize profits Different assets have different level of liquidity and profitability The LP dilemma: If bank emphasize on liquidity, profitability will be sacrifice

Bank Financial Statements: Balance Sheet Fixed Assets Current Assets - Cash and short term funds - Securities purchased under resale agreement (REPO) - Deposits and placements with banks and other financial institutions Securities held for trading Investment securities Loans, advances and financing Other assets Investment in subsidiary companies Investment in associate companies

Bank Financial Statements: Income Statement Interest Income (-) Interest Expense (=)Net Interest Income (-) Allowance for losses on loans, advances and financing (+)Non-Interest Income (=)Net Income Net Income (-) Overhead Expenses (=) Profit Before Tax (-) Tax (=) Net Profit After Tax (-) Transfer to Statutory Reserves (=) Net Profit After Transfer to Statutory Reserves

Bank Financial Statements: Income Statement Net Profit After Transfer to Statutory Reserves (+) Retained Profit Brought Forward (+) Distributable Profit (-) Proposed Dividend (=) Retained Profit Carried Forward Earnings Per Share

Asset Management How the bank invest its assets / funds to maximize its shareholders wealth As the liquidity and profitability differ from one assets to another, banks must take into consideration the liquidity-profitability (LP) Dilemma

LP Dilemma Exist because the degrees of liquidity and profitability are different across different assets Attributed by conflicting goals among depositors, shareholders and controlling party Shareholders expect high return, depositors desire maximum liquidity

LP Dilemma LP Dilemma = to find a method that can strike a balance between risk & return, liquidity & profitability Three methods; Fund pool method Assets allocation method Management science method

Fund Pool Method Fund from all sources are pooled together to create a single source of funds The funds are distributed to the various predetermined categories of assets based of their degree of importance

Fund Pool Method Example Current deposits 200 Savings deposits 100 Fixed deposits 100 REPO 50 NCD’s 50 Debentures 100 Total 600 Reserve based 20% Statutory reserves 10% Secondary reserves 20% Loan portfolio 30% Allocation by sectors; Agriculture 10% Manufacturing 50% Real estate 20% Service 20%

Disadvantaged of Fund Pool Method Over emphasize on liquidity at the expense of profitability Does not provide any specific basis for purpose of estimating liquidity standards does not take into consideration the volatility of deposits accounts Does not recognized source of liquidity

Assets Allocation Method Banks are forced to utilize deposits more efficiently and effectively as a result of competition from non-bank financial institutions in terms of deposits acquisitions and use funds in a more profitable way Assets allocation method treats each source of fund individually in view of the different degrees of volatility among them. Each source of funds is treated as a profit centre Short (long) term assets should be financed by short (long) term financing

Disadvantages of Assets Allocation Method May overestimate the liquidity of deposits accounts Does not recognized loan portfolio as a source of liquidity Asset & liability management decisions are made separately does not provide specific guidelines on the allocation of funds among different categories of bank assets

Management Science Method a.k.a Linear programming method A mathematical procedure to choose variable values for purpose of maximizing (minimizing) an objective, subject to certain restrictions Helps to determine the required balance sheet quantity set in order to maximize bank profitability subjects to restrictions in trems of liquidity and other fixed rules

Management Science Method Example Bank A has funds totaling RM25 million which can be invested in loan assets (X1) and secondary reserves (X2). The funds made up of current deposits and fixed deposits. The rate of return is estimated at 12% while short term securities 8%. Let’s assume that the bank income is net income after deducting the cost of deposits. The management bank of bank A has stipulated the bank’s liquidity standard of RM2 in short term securities for every RM10 investment in fixed assets

Bank Liquidity 5 factors why banks must have adequate liquidity; Confidence Relationship Force sale Risk premium Last chance

Bank Liquidity Theory Commercial Financing A bank is considered liquid if its loan portfolio consist of short term financing only Maturity dates of financing coincides with maturity dates of deposits Stability Bank invest part of their funds in loan portfolio & secondary markets This theory prolongs the average maturity period of loans portfolios

Bank Liquidity Theory Expected Income Bank liquidity can be acquired through loan repayments Loan repayment should be match with loan income Acknowledges that loan portfolio is a source of liquidity Liability Management Banks can fulfill liquidity requirements by borrowing from the money and capital markets Borrowed funds acquired for the purpose of bank liquidity are sometimes called purchased funds

Liquidity Measurement No one single specific measurement standards However loan to deposit ratio is used widely to measure liquidity As the ratio increases, bank liquidity decreases Loan interest increase in tandem with the increase in loan to deposit ratio since the demand for credit exceeds supply

Disadvantages of Loan to Deposits Ratio Does not show the maturity or quality of loan portfolio Does not provide any truth about bank liquidity needs. Banks that provides more for speculative loans are more likely to face liquidity problems Does not provide any information on other assets of a bank other than its loan portfolio

Other Liquidity Measurement 1. Cash Assets / Total Assets 2. (Cash Assets – Statutory Reserve + Marketable Government Securities of Less than One year Maturity) / Total Deposits 3. (Cash Assets – Reserve + Government Securities) / Total Deposits 4. (Cash Assets + Government Securities) / Total Deposits

Estimating Credit Requirement Please refer to worksheet

Izdihar Baharin @ Md Daud Thank You! Izdihar Baharin @ Md Daud Post Graduate Centre HP: 006019-5170817 Email: izdi@oum.edu.my