1. Lecture 18: Bank risk management
Mishkin Ch 9 – part B
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2. Outline: Liquidity Management Asset Management Liability Management
enough cash and liquidity assets to pay depositors
Asset Management
diversifying investment
Liability Management
low cost of getting funds
Capital Adequacy Management
required by regulators
manage credit risk
manage interest-rate risk
manage risks in off-balance-sheet activities 2 2

3. Asset management
Goal of asset managements is to seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity.
Find good quality borrowers
Purchase securities optimally
Lower risk by diversifying
Balance need for liquidity against increased returns from less liquid assets.

4. Liability management Target: acquire funds with low costs.
The old way: checkable deposits
New trend since 1960s:
borrow funds in overnight loan markets (e.g. fed funds market)
New financial instruments (e.g. negotiable CDs)

5. Capital adequacy management
Why capital adequacy is beneficial?
Bank capital is a cushion that helps prevent bank failure.
Regulatory requirement.
Why might banks want to hold less bank capital?
The amount of capital affects return for the owners (equity holders) of the bank.

6. Prevent bank failure
Bank failure: a bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its reserve requirements .
Holding adequate bank capital helps prevent bank failures because it can be used to absorb the losses resulting from a deposit outflow.

7. Prevent bank insolvency
insolvent: liabilities > assets  neg. net worth
Bank capital decrease the chance of insolvency.
High Bank Capital
Low Bank Capital
Assets
Liabilities
Reserves
$10M
Deposits
$90M
$96M
Loans
Bank Capital
$4M
$85M
$5M
-$1M
Loan written offs

8. Returns to equity holders
Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

9. Safety – ROE tradeoff Increase bank capital is:
benefit to the owners of a bank by making their investment safe (avoid bank failure).
costly to owners of a bank because the higher the bank capital, the lower the return on equity.
Choice depends on the state of the economy and levels of confidence.
e.g. in more uncertain times, when the possibility of large losses on loans increases, bankers might want to hold more bank capital.

10. Managing credit risk
Adverse selection and moral hazard between the bank and investors  credit risk (risk that loans not paid back in full)
Measures:
Screening and monitoring
screening and information collection
specialization in lending
monitoring and enforcement of restrictive covenants

11. Managing credit risk – cont’d
Measures (cont’d)
Long-term customer relationships
Loan commitments
Collateral and compensating balances
Credit rationing 11 11

12. Interest-rate risk - example
Bank
Assets
Liabilities
Rate-sensitive assets
$20M
Rate-sensitive liabilities
$50M
Fixed-rate assets
$80M
Fixed-rate liabilities
$40M
Interest rate increase 5%  interests earned from asset increase $1M, interest cost from liabilities increase $2.5M  profit decrease $1.5M
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits .

13. Gap analysis GAP = rate-sensitive assets – rate-sensitive liabilities
Profits = i  GAP
When interest rate increase 5%:
GAP = $20 – $50 = –$30 million
Profits = 5%  ( – $30m) = –$1.5m 13

14. Duration analysis
Duration is the average lifetime of a security’s stream of payments. 14

15. Duration analysis - example
Suppose:
Bank assets is $100M and liabilities is $90M
duration of bank assets is 3 years
duration of liabilities is 2 years;
Now: interest rate increase 5%,
Calculate:
% assets = –5%  3 = –15%
% liabilities = –5%  2 = –10%
assets value decrease$15M, liabilities decrease $9M
bank’s net worth decrease $6M 15

16. Managing interest-rate risks
GAP analysis focus on interest gain (loss) from asset and liabilities that are most sensitive to interest rate changes.
Duration analysis examines the sensitivity of the market value of the bank’s total assets and liability to interest-rate changes.
Need to adjust holdings of assets and liabilities to reduce interest rates risk when risks are too high. 16

17. Off-balance-sheet activities
Loan sales (secondary loan participation)
Generation of fee income
Examples: servicing mortgage-backed securities, guarantees of debt, etc.
Trading activities
Examples: futures market trading
Principal-agent problem

18. Managing risk in off-balance-sheet activities
Internal controls:
Separation of front and back rooms
Limit risky exposure
Value-at-risk modeling
Stress testing