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

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

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)

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.

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

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

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.

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

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 + 100 Cash in the process of collection +100 Checkable dep Melisa + 100 Felix + 100

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 + 100 Giro acct at Central bank + 100 Checkable dep Melisa + 100 Felix + 100 BCA Assets Liabilities Reserves Giro acc at Central bank - 100 Checkable dep Felix - 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

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 + 20 Excess reserves + 180 Checkable dep Melisa + 100 Felix + 100 Assets Liabilities Reserves Required reserves + 20 Excess reserves + 180 - 180 Loans + 180 Checkable dep Melisa + 100 Felix + 100

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% * 200 + 20 10% * 180 + 18 Excess reserves + 180 - 180 + 162 .Loans to PT X + 180 to PT Y + 162 Checkable dep Melisa + 100 Felix + 100 PT X + 180 PT Y + 162

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”.

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

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).

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

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

Liquidity management What the bank will do?

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

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.

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.

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 

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

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

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.

Banks' Income Statement

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

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)

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