Chapter 9

Banking and
the Management
of Financial
Institutions
 Preview

• This chapter examines how banks attempt to

maximize their profits.

• Although the discussion that follows focuses

primarily on commercial banks, many of the same
principles apply to other financial intermediaries as
well.

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 Learning Objectives

• Summarize the features of a bank balance sheet.

• Apply changes to a bank’s assets and liabilities on a

T-account.

• Identify ways in which banks can manage their

assets and liabilities to maximize profit.

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 Learning Objectives

• List the ways in which banks deal with credit risk.

• Apply gap and duration analysis and identify

interest-rate risk.

• Examine off-balance sheet activities.

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 The Bank Balance Sheet

• Liabilities (Sources of funds):

– Checkable deposits
– Non-transaction deposits
– Borrowings
– Bank capital

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 Checkable Deposits

• Write checks on account

• Types:
➢ Non-Interest Bearing Checking Accounts
➢ Interest-Bearing NOW
➢ MMDAs

• Costs

• Liquidity

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 Nontransaction Deposits

• Types:
➢ Savings Accounts [monthly statements or passbook]

➢ Time Account [fixed maturity length, CDs]

- small denominations
- large denominations, NCDs

• Cost

• Liquidity

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 Borrowings

• From Central Banks (discount loans - advances)

• Overnight Interbank Market

• Corporations
✓ Parent companies (bank holding companies)
✓ REPOs
✓ Eurocurrencies

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 Bank Capital

• Net worth of the bank (total assets – total liabilities)

• Raised by:
➢ Selling new equity (stocks)
➢ Retained earnings

• Cushion against drop of assets value

• Secures against Insolvency (L>A→liquidation)

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 The Bank Balance Sheet

• Assets (Uses of funds):

– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets

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 Reserves

• Accounts at Central Bank + Vault Cash

• Required Reserves + Excess Reserves

• Most liquid Asset

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 Cash Items in Process of Collection

• Checks not collected yet

• Liquidity

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 Deposits at Other Banks

• Small banks hold them in large banks in exchange

for services (correspondent banking):

➢ Check collection
➢ Foreign exchange transactions
➢ Securities purchases

• Reserves + Cash items in process of collection +

deposits at other banks → cash items

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 Securities

• Income-Earning Assets (debt instruments)

• Treasury Bills (secondary reserves)

➢ Easily traded
➢ Converted into cash with low transaction costs

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 Loans

• Primary source of bank profits

• Less liquid than other assets (liquidated at maturity)

• Higher risk/high return

Other Assets

• Physical capital owned by banks

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 Table 1 Balance Sheet of All Commercial Banks
(items as a percentage of the total, June 2014)

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 Basic Banking

• Asset Transformation: Banks make profits by selling

liabilities with one set of characteristics (liquidity, risk, size, &
return) and use the proceeds to buy assets with a different set of
characteristics.

• Banks “borrow short & lend long”.

• T-account : simplified balance sheet listing only the changes

that in the balance sheet items starting from initial balance
sheet position.

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 Basic Banking

Cash Deposit:

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100

Cash deposits deposits

• Opening of a checking account leads to an increase in the

bank’s reserves equal to the increase in checkable deposits.

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 Basic Banking

First National Bank Check Deposit:

When a bank receives
Assets Liabilities additional deposits, it gains an
Cash items in +$100 Checkable +$100 equal amount of reserves; when it
process of deposits loses deposits, it loses an equal
collection amount of reserves.

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits

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 Basic Banking

Making a profit:
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Required +$10 Checkable +$100 Required +$10 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves

• Bank officers evaluate potential borrowers using “five C’s”

(character, capacity, collateral, conditions, & capital) to reduce
problems of asymmetric information.

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 General Principles of Bank Management

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk

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 Liquidity Management and the Role
of Reserves

Excess reserves:

Assets Liabilities Assets Liabilities

Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M

– Suppose a bank’s required reserves are 10%.

– If a bank has ample excess reserves, a deposit outflow

does not necessitate changes in other parts of its balance
sheet.

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 Liquidity Management and the Role
of Reserves

Shortfall:

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M

– Reserves are a legal requirement and the shortfall must

be eliminated.

– Excess reserves are insurance against the costs associated

with deposit outflows.

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 Liquidity Management and the Role
of Reserves (Four Basic Options)

I. Borrowing:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

– Cost incurred is the interest rate paid on the borrowed

funds

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 Liquidity Management and the Role
of Reserves

II. Securities sale:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M

– The cost of selling securities is the brokerage and other

transaction costs.

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 Liquidity Management and the Role
of Reserves

III. Federal Reserve:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M

– Borrowing from the Fed also incurs interest payments

based on the discount rate.
– Too much borrowing restricts borrowing in the future.

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 Liquidity Management and the Role
of Reserves
IV. Reduce loans:

Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M

– Reduction of loans is the most costly way of

acquiring reserves.
– Calling in loans antagonizes customers.
– Other banks may only agree to purchase loans at a
substantial discount (selling off loans).

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 Think!!!!!

• If the bank you own has no excess reserves and a

sound customer comes in asking for a loan, should
you automatically turn the customer down,
explaining that you don’t have any excess reserves
to lend out? Why or why not? What options are
available that will enable you to provide the funds
your customer needs?

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 Asset Management

•To maximize profits, a bank must simultaneously

seek three goals:
1. The highest possible returns on loans and securities.
2. Reduce risk.
3. Have adequate provisions for liquidity.

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 Asset Management

• Banks accomplish these goals through four tools:

1. Find borrowers who will pay high
interest rates and have low possibility
of defaulting.

2. Purchase securities with high returns and low risk.

3. Lower risk by diversifying.

4. Balance need for liquidity against increased returns from

less liquid assets.

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 Think!!!!!

• “Bank managers should always seek the highest

return possible on their assets.” Is this statement
true, false, or uncertain? Explain your answer.

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 Liability Management

• Recent phenomenon due to rise of money center

banks

• Expansion of overnight loan markets and new

financial instruments (such as negotiable CDs)

• Checkable deposits have decreased in importance

as source of bank funds.

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 Capital Adequacy Management

• Bank capital helps prevent bank failure.

• The amount of capital affects return for the owners

(equity holders) of the bank.

• Regulatory requirement

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 Capital Adequacy Management

How Bank Capital Helps Prevent Bank Failure:

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 Capital Adequacy Management

How the Amount of Bank Capital Affects Returns to Equity

Holders:

Return on Assets: net profit after taxes per dollar of assets

net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
= 
equity capital assets equity capital
ROE = ROA  EM

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 If a bank finds that its ROE is too low because it has too
much bank capital, what can it do to raise its ROE?

• To lower capital and raise ROE, holding its assets constant, it

can

➢ pay out more dividends

➢ buy back some of its shares

• Or it can keep its capital constant, but increase the amount of

its assets by acquiring new funds and then seeking out new
loan business or purchasing more securities with these new
funds (expansion in lending).

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 Capital Adequacy Management

• Trade-off between safety and returns to equity

holders:

– Benefits the owners of a bank by making their investment

safe

– 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

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 Think!!!!!

• Why do equity holders care more about ROE than about ROA?

• If the president of a bank told you that the bank was so well
run that it has never had to call in loans, sell securities, or
borrow as a result of a deposit outflow, would you be willing
to buy stock in that bank? Why or why not?

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 Managing Credit Risk

• Control Default & asymmetric Information

• Being nosy

• Screening and Monitoring

– Screening (personal finances – business loans)
– Specialization in lending ( location – activity)
– Monitoring and enforcement of
restrictive covenants

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 Managing Credit Risk

• Long-term customer relationships (KYC – bank

benefits – customer benefits)

• Loan commitments (bank commitment, for a specified

future period of time, to provide a firm with loans with agreed
characteristics)

• Collateral and compensating balances (checking

account)

• Credit rationing (two forms)

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 Think!!!!!

• “Because diversification is a desirable strategy for

avoiding risk, it never makes sense for a bank to
specialize in making specific types of loans.” Is this
statement true, false, or uncertain? Explain your
answer.

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 Managing Interest-Rate Risk

• If a bank has more rate-sensitive liabilities (costs) than assets

(earnings), a rise in interest rates will reduce bank profits and
a decline in interest rates will raise bank profits.

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 Think!!!!!

• If you are a banker and expect interest rates to rise

in the future, would you prefer to make short-term
loans or long-term loans?

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 Gap Analysis
• Measures sensitivity of bank profits to changes in interest
rates.

• Basic gap analysis:

(rate sensitive assets - rate sensitive liabilities) x  interest rates =  in bank
profit

• Maturity bucket approach:

– Measures the gap for several maturity subintervals

• Standardized gap analysis:

– Accounts for different degrees of rate sensitivity

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 Think!!!!!

• Suppose you are the manager of a bank that has $15 million
of fixed-rate assets, $30 million of rate-sensitive assets, $25
million of fixed-rate liabilities, and $20 million of rate-sensitive
liabilities. Conduct a gap analysis for the bank, and show what
will happen to bank profits if interest rates rise by 5
percentage points. What actions could you take to reduce the
bank’s interest-rate risk?

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 Duration Analysis

• Examines the sensitivity of the market value of the bank’s total

assets and liabilities to changes in interest rates.

% in market value of security  - percentage point  in interest

rate x duration in years.

• Uses the weighted average duration of a financial institution’s

assets and of its liabilities to see how net worth responds to
a change in interest rates.

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 Think!!!!!

• Suppose you are the manager of a bank whose $100 billion of

assets have an average duration of four years and whose $90
billion of liabilities have an average duration of six years.
Conduct a duration analysis for the bank, and show what will
happen to the net worth of the bank if interest rates rise by 2
percentage points. What actions could you take to reduce the
bank’s interest-rate risk?

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 Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)

• Generation of income from fees banks receive for

providing specialized services to customers (foreign
exchange trade)

• Trading activities and risk management techniques

(futures, options, swaps)

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