KUWAIT UNIVERSITY
COLLEGE OF BUSINESS ADMINISTRATION
DEPARTMENT OF ECONOMICS
Money & Banking
Econ240
Instructor Notes
Mahmoud Arab
TEACHING ASSISTANT
Kuwait University Econ240 Mahmoud Arab
Chapter 9: Management of Banking
and Financial Institutions
(Part 1)
❖ The Bank Balance Sheet:
1. Liabilities (Source of funds):
i) Checkable deposits:
(1) deposits in bank accounts that allow their owners to write checks.
(2) Examples: Demand deposits, Negotiable Order of Withdrawal (NOW) accounts,
Money Market Deposit Accounts (MMDAs)
(3) a bank’s lowest-cost source of funds
ii) Nontransaction deposits:
(1) Owners cannot write checks on nontransaction deposits.
(2) Examples: Savings deposits, certificates of deposit or CDs
iii) Borrowings:
(1) Borrowings from the Federal Reserve = discount loans.
(2) Borrowings from other banks = federal funds.
(3) Borrowings from non-bank corporations = repurchase agreements.
iv) Bank capital:
(1) Capital (Net Worth) = Assets - Liabilities
2. Assets (Uses of Funds / Sources of Revenue and Income):
i) Reserves:
(1) Required reserves (RR): By law, the bank must hold a certain fraction (10%) of
every dollar of checkable deposits
(2) Excess Reserves (ER): additional reserves held by the bank to meet its customers’
requests for withdrawals.
ii) Cash items in process of collection:
(1) A check that had been deposited at the bank, but not yet collected from the check
writer’s bank, is a cash item in the process of collection.
iii) Deposits at other banks:
(1) Many small banks hold deposits at larger banks
(2) the large banks provide services such as check collection and help with securities
purchases.
iv) Securities
(1) Securities: Only government securities (State and local government)
(2) By law, banks can only hold debt instruments; they cannot own equities
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Kuwait University Econ240 Mahmoud Arab
v) Loans:
(1) Business
(2) Mortgages
(3) Consumer (e.g. overdrafts and credit card loans)
(4) Banks (interbank loans)
vi) Other assets:
(1) Physical assets owned by banks: buildings and land, computers and office
equipment
❖ Basic Operation of a Bank: T-accounts:
• Asset transformation:
i) Banks sell liabilities with one set of characteristics and use the proceeds to acquire
assets with a different set of characteristics.
ii) Example: bank will accept a savings deposit from one customer and use the proceeds
to make a mortgage loan to another customer
Assets Liabilities
Liquidity Low High
Risk High Low
Return High Low
• T-account:
i) Simplified set of the format as a balance sheet that lists only the changes on each side
that occur as a result of specific bank operations.
ii) Each operation always affects TWO items in the balance sheet.
• How banks engage in asset transformation?
i) Cash Deposit: suppose a customer deposit a $100 bill into his/her checking account
in the First National Bank.
A cash deposit → increase in the bank’s reserves equal to the increase in checkable deposits.
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Kuwait University Econ240 Mahmoud Arab
ii) Check Deposit: suppose a customer deposits a check for $100 written on an account
for a First National Bank.
After clearing the check
When a bank receives additional deposits → it gains an equal amount of reserves
When a bank loses deposits → it loses an equal amount of reserves
iii) Making a profit: suppose the First National Bank receives $100 in checkable
deposits and hence $100 in additional reserves. And suppose by law, the bank must
hold 10% (Required Reserved Ratio-RRR) as required reserves.
(a) Asset transformation
(b) The bank borrows short and lends long
Since reserves pay no interest rate, and since First National Bank is not required to hold excess
reserves, it may decide to use the $90 to make a new loan to one of its other customers →
Maximum loans the First National Bank can lend = Excess Reserves
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Kuwait University Econ240 Mahmoud Arab
Suppose: First National Bank charges a 10% interest rate loans
First National Bank sets a 5% interest rate on deposits
First National Bank has management cost and other costs = 3$
First National Bank Profit = Bank Revenue - Bank Cost
Bank Revenue = interest rate loans × loans
= 10% × $90
= $9
Bank Cost =(interest rate on deposits × Deposits) + (management cost and other costs)
= 5% × $100 + ($3)
= 5+3
=$8
Bank Profit = Bank Revenue - Bank Cost
= $9 – $8
= $1
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Kuwait University Econ240 Mahmoud Arab
Chapter 9: Management of Banking
and Financial Institutions
(Part 2)
❖ General Principles of Bank Management:
3. Liquidity Management:
i) Making sure that the bank has enough cash to cover depositors’requests for
withdrawals (deposit outflows).
ii) Deposit Outflows:
(a) Holding excess reserves: a bank can cope with a deposit outflow without
changing any other part of its balance sheet.
(b) Holds no excess reserves: the bank manager must take an action in response
to deposit outflow:
(i) Option 1: Borrow reserves: as a discount loan from the Federal Reserve,
borrow from another bank in the federal funds market, or borrow from a
non-bank corporation by entering a repurchase agreement → The bank’s
borrowings will increase in the Liabilities → Reserves increases by the
same amount in the Assets side of the balance sheet → increase in both
Assets and Liabilities sides of the balance sheet
(ii) Option 2: Sell securities → Reserves increases by the same amount in the
Assets side of the balance sheet.
(iii) Option 3: Reduce its loans. → Reserves increases by the same amount in
the Assets side of the balance sheet. This option may be the most costly of
all, since it might antagonize the bank’s customers who want to borrow.
• If the bank decides to take option 2&3 in response to deposit outflow → Liabilities side
of the balance sheet will not be affected
• All these options are costly. excess reserves provide insurance against these costs. A
bank might hold some excess reserves even though reserves do not pay interest.
4. Asset Management:
i) Acquiring assets with the highest return and the lowest risk.
ii) Goals:
(1) Seek the highest possible returns on loans and securities.
(2) Reduce risk.
(3) Have adequate liquidity.
iii) Tools:
(1) Finding borrowers who will pay high interest rates but who are unlikely to
default.
(2) Finding securities with high returns and low risk.
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Kuwait University Econ240 Mahmoud Arab
(3) Diversifying the bank’s asset holdings to minimize risk: holding many types of
securities and making many types of loans offers protection when there are losses
in one type of security or one type of loan.
(4) Holding some liquid assets, including excess reserves and US Treasury bills
(“secondary reserves”), to protect against deposit outflows, even though the
interest rate on these assets may be lower.
5. Liability Management:
i) Banks no longer primarily depend on sight and time deposits as primary bank funds
ii) When banks see loan opportunities, they borrow from other banks in the
interbank market or issue CDs to raise funds
iii) Goal: Minimize cost of deposits and borrowing
6. Capital Management:
i) Capital (Net Worth) = Assets – Liabilities
ii) Serves as a cushion to prevent bank failure
iii) Banks hold capital to meet capital requirements as necessary buffer against losses.
High Capital Bank still has
Bank positive net
value of their worth
Two Banks
liabilities
have made
loans at both remains
loans to a
banks falls unchanged,
company that
both banks also
goes bankrupt
lose in capital
Low Capital Insolvent
Bank (bankrupt).
iv) Strategies for Managing Bank Capital:
(1) Buy back/issue new stocks
(2) Pay higher/lower dividends to stockholders
(3) Increase/decrease bank’s asset (change of bank capital relative to assets)
v) What is the Amount of Bank Capital Affects Returns to Equity Holders?
net profits after taxes (P)
ROA (Returns on Assets) = Assets (A)
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Kuwait University Econ240 Mahmoud Arab
net profits after taxes (P)
ROE (Returns on Equity) =
equity capital (E)
Assets (A)
EM (Equity multiplier) = equity capital (E)
ROE = ROA × EM
Bank faces a
trade-off
Protection against a
decline in the value Pay more dividends
of its assets
High Capital Bank Less Capital Bank
i) Bank Capital Managements Applications:
1) Bank Manager Conclusion: a shortfall of bank capital is likely to lead a bank to
reduce its assets and therefore is likely to cause a contraction in lending.
2) Capital Crunch Caused a Credit Crunch During the Global Financial Crisis:
i. Shortfalls of bank capital led to slower credit growth
ii. Banks could not raise much capital on a weak economy and had to tighten
their lending standards and reduce lending
7. Credit Management:
i) Screening and Monitoring:
(1) Screening
(2) Specialization in lending
(3) Monitoring and enforcement of restrictive covenants
(4) Long-term customer relationships
(5) Loan commitments
(6) Collateral and compensating balances
(7) Credit rationing
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Kuwait University Econ240 Mahmoud Arab
8. Interest Rate Risk Management:
A. Interest rate effect on bank’s profit: (returns):
1) remember that asset is source of revenue (income) and liabilities is source of fund for
the banks (cost)
2) interest rate vs. (income & cost):
i. Increasing interest rate → banks will earn more from increasing the interest
rate on loan → increases the revenue from the loans → income increases.
vice versa
ii. Increasing interest rate → the interest rate on deposits and borrowing (from
other banks, central bank) increases → The cost of getting sources of fund
(liabilities) increases. vice versa
Assets (Income)
Direct Relationship (+) Interest Rate
Liabilities (Cost)
3) Δ Bank Profit = ΔIncome – ΔCost
ΔIncome = Δinterest × Rate sensitive assets (RSA)
Δcost = Δinterest × Rate sensitive liabilities (RSL)
4) GAP = Rate sensitive assets (RSA) – Rate sensitive liabilities (RSL)
ΔBank Profit = (Rate sensitive assets – Rate sensitive liabilities) × Δinterest rates%
The Effect of a Change in Interest Rate (i) on Bank’s Profits
RSA > RSL RSA < RSL RSA=RSL
Increase in i
Decrease in i
B. Interest rate effect on Bank’s Capital: (Net worth):
1) Examines the sensitivity of market value of the banks’ total assets and liabilities to
changes in interest rate.
2) Interest rate vs. Market value for assets and liabilities (price):
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Kuwait University Econ240 Mahmoud Arab
i. Inverse relationship between price (p) and interest rate
𝟏
𝑷𝒓𝒊𝒄𝒆 (𝑷) = 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 (𝒊)
ii. Increasing interest rate → the price of both assets and liabilities (market
value) will decrease. vice versa
3) The effect of interest rate on Assets:
%Δ Assets = - Δ interest × Average Asset Duration
Δ Assets ($) = %ΔAssets × Assets ($)
Δ Assets ($) = (- Δ interest × Average Asset Duration) × Assets ($)
4) The effect of interest rate on Liabilities:
%Δ Liabilities = - Δinterest × Average Liabilities Duration
Δ Liabilities ($) = %ΔLiabilities × Liabilities ($)
Δ Liabilities ($) = (- Δinterest × Average Liabilities Duration) × Liabilities ($)
5) The effect of interest rate on bank’s capital (net worth):
ΔBank’s Capital (Net worth) = Δ Assets ($) – Δ Liabilities ($)
The Effect of a Change in Interest Rate (i) on Bank’s Capital
Interest rate / Duration AD > LD AD < LD AD=LD
Increase in i
Decrease in i
* AD: Asset Duration; LD: Liabilities Duration
6) When duration of assets is larger than the duration of liabilities:
(a) If interest rates rise → the market value for assets will lose more than the
market value for liabilities → thus reducing the value of the firm's equity.
(b) If interest rates fall → the market value for assets will increase more than the
market value for liabilities → thus increasing the value of the firm's equity.
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Kuwait University Econ240 Mahmoud Arab
7) When the duration of assets is less than the duration of liabilities:
i. If interest rates rise → the market value for liabilities will lose more than the
market value assets → thus increasing the value of the firm's equity.
ii. If interest rates decline → the market value for liabilities will gain more than
the market value than assets → thus decreasing the value of the firm's equity.
9. Off-Balance-Sheet Activities:
i) Result of the competitive environment of recent years.
ii) Generate profits from activities not appearing in the balance sheet:
(1) Loan sales
(2) Fees from specialized services linked to securitization, derivative and foreign
exchange transactions, guarantees of securities and backup credit lines.
(3) These services do not appear in balance sheet, but dramatically affect the risk that
the bank face
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