1. Banking and the Management of Financial Institutions
Lecture - 19

2. Basics of Banking
Before we explore the main role of banks—that is, asset transformation—it is helpful to understand some of the simple accounting associated with the process of banking.

3. Basics of Banking T-account Analysis:
Deposit of $100 cash into First National Bank

4. Basics of Banking Deposit of $100 check
Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount

5. Basics of Banking
This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded.

6. Basics of Banking T-account Analysis:
Deposit of $100 cash into First National Bank

7. Basics of Banking
As we can see, $10 of the deposit must remain with the bank to meeting federal regulations. Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers.

8. Basics of Banking T-account Analysis:
Deposit of $100 cash into First National Bank

9. General Principles of Bank Management
Liquidity management
Asset management
Managing credit risk
Managing interest-rate risk
Liability management
Managing capital adequacy

10. Principles of Bank Management

11. Principles of Bank Management
With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

12. Liquidity Management
With 10% reserve requirement, bank has $9 million reserve shortfall

13. Liquidity Management

14. Liquidity Management
Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows

15. Asset Management
Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk.
Get borrowers with low default risk, paying high interest rates
Buy securities with high return, low risk
Diversify – giving loans to different businesses

16. 4. Liquidity management
The bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without bearing huge costs.
The bank must decide how much in excess reserves must be held to avoid costs from a deposit outflow.
Liquid securities like T-bonds ensures that the costs from a deposit outflow will not be severe

17. Liability Management
Liability Management: managing the source of funds, from deposits, to CDs, to other debt.
Important since 1960s. Before 1960, liabilities management was not important because:
Interest rate was not paid on checkable deposits
No longer primarily dependent on deposits
When see loan opportunities, borrow or issue CDs to acquire funds

18. Capital Adequacy Management
Banks have to make decisions about the amount of capital they need to hold for three reasons.
First, bank capital helps prevents bank failure, Second, the amount of capital affects returns for the owners
And third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities

19. Capital Adequacy Management
Because owners of a bank must know whether their bank is being managed well, they need good measures of bank profitability
ROA = Net Profits/Assets
However, what the bank’s owners (equity holders) care about most is how much
the bank is earning on their equity investment.
ROE = Net Profits/Equity Capital

20. There is a direct relationship between the return on assets (which measures how efficiently the bank is run) and the return on equity (which measures how well the owners are doing on their investment). This relationship is determined by the so-called
equity multiplier (EM), which is the amount of assets per dollar of equity capital
EM = Assets/Equity Capital
ROE = ROA  EM
Capital , EM , ROE 

21. Capital Adequacy Management
Tradeoff between safety (high capital) and ROE
In more uncertain times, when the possibility of large losses on loans increases, bank managers might want to hold more capital to protect the equity holders
Conversely, if they have confidence that loan losses won’t occur, they might want to reduce the amount of bank capital, have a high equity multiplier, and thereby increase the return on equity.

22. Off-Balance-Sheet Activities
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

23. Measuring Bank Performance
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.

24. Banks' Income Statement

25. Measuring Bank Performance
As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows both calculations and historical averages for key bank performance measures.

26. Recent Trends in Bank Performance Measures
ROA = Net Profits/ Assets
ROE = Net Profits/ Equity Capital
NIM = [Interest Income - Interest Expenses]/ Assets
NIM is a combined measure of bank liability and assets management