Management of Financial Institution Chapter Three

CHAPTER THREE
BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS
Introduction
A financial institution is an intermediary between consumers and the capital or the debt markets
providing banking and investment services. A financial institution is responsible for the supply
of money to the market through the transfer of funds from investors to the companies in the form
of loans, deposits, and investments.
The most common types of financial institutions include commercial banks, investment banks,
brokerage firms, insurance companies, and asset management funds. Other types include credit
unions and finance firms. Financial institutions are regulated to control the supply of money in
the market and protect consumers.
3.1. The Bank Balance Sheet
A balance sheet (statement of financial position) is a financial report that shows the value of a
company's assets, liabilities, and owner's equity on a specific date, usually at the end of an
accounting period, such as a quarter or a year. An asset is anything that can be sold for value. A
liability is an obligation that must eventually be paid, and, hence, it is a claim on assets. The
owner's equity in a bank is often referred to as bank capital, which is what is left when all assets
have been sold and all liabilities have been paid. The relationship of the assets, liabilities, and
owner's equity of a bank is shown by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as deposits
or borrowings, to finance assets, such as loans to individuals or businesses, or to buy interest
earning securities, the owners of the bank can leverage their bank capital to earn much more than
would otherwise be possible using only the bank's capital.
Assets and liabilities are further distinguished as being either current or long-term. Current assets
are assets expected to be sold or otherwise converted to cash within 1 year; otherwise, the assets
are long-term (noncurrent assets). Current liabilities are expected to be paid within 1 year;
otherwise, the liabilities are long-term (noncurrent liabilities). Working capital is the excess of
current assets over current liabilities, a measure of its liquidity, meaning its ability to meet short-
term liabilities:
Working Capital = Current Assets – Current Liabilities
Generally, working capital should be sufficient to meet current liabilities. However, it should not
be excessive, since capital in the form of long-term assets usually has a higher return. The excess
of the bank's long-term assets over its long-term liabilities is an indication of its solvency, its
ability to continue as a going concern.
A bank’s balance sheet summarizes its financial position at a specific time. It shows what the
bank owns (assets) and owes (liabilities), as well as its equity or capital (the difference between
assets and liabilities).
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A. Assets (Uses of Funds); these represent how the bank uses its funds to earn income.
1. Reserves:
o Cash kept in the bank or with the central bank.
o Used to meet customer withdrawals and regulatory requirements.
o Non-earning asset (does not generate profit directly).
2. Loans:
o The largest portion of bank assets.
o Include commercial loans, consumer loans, mortgage loans, and overdrafts.
o Generate interest income but involve risk of default.
3. Securities (Investments):
o Government bonds, treasury bills, and corporate securities.
o Provide liquidity and interest income.
o Less risky than loans.
4. Other Assets:
o Physical assets like buildings and equipment.
o Accounts receivable and accrued interest.
B. Liabilities (Sources of Funds); these represent how the bank obtains funds.
1. Deposits:
o Demand deposits: Checking accounts, withdrawal anytime.
o Savings deposits: Earn interest, more stable.
o Time deposits (fixed deposits): Locked for a certain period with fixed interest.
2. Borrowings:
o Loans from other banks or the central bank (e.g., discount loans).
o Used to manage short-term liquidity needs.
3. Other Liabilities:
o Accrued expenses, taxes payable, and other obligations.

C. Bank Capital (Owner’s Equity)

 Represents owners’ investment and retained earnings.
 Acts as a financial cushion against losses.
 Used to measure solvency and capital adequacy.
Authorized Capital; Maximum amount of capital that can be collected by the bank as permitted
by Memorandum of Associations. Only a portion of the authorized capital will be issued to the
public for subscriptions.
Issued Capital; Portion of capital offered to public for subscriptions
Paid-up Capital; Actual amount of money received from the shareholders

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3.2. General Principles of Bank Management

Bank management refers to the planning, organizing, directing, and controlling of a bank’s
resources both financial and human to achieve its objectives of profitability, liquidity, and
solvency while maintaining public confidence and complying with regulations. Because banks
deal mainly with other people’s money (deposits), they must operate efficiently and safely. This
makes sound management essential.

Bankers must manage their assets and liabilities to ensure three conditions:
1. Their bank has enough reserves on hand to pay for any deposit outflows (net decreases in
deposits) but not so many as to render the bank unprofitable. This tricky trade-off is called
liquidity management.
2. Their bank earns profits. To do so, the bank must own a diverse portfolio of remunerative
assets. This is known as asset management. It must also obtain its funds as cheaply as possible,
which is known as liability management.
3. Their bank has sufficient net worth or equity capital to maintain a cushion against bankruptcy
or regulatory attention but not so much that the bank is unprofitable. This tricky trade-off is
called capital adequacy management.
In their quest to earn profits and manage liquidity and capital, banks face two major risks: credit
risk, the risk of borrowers defaulting on the loans and securities it owns, and interest rate risk, the
risk that interest rate changes will decrease the returns on its assets and/or increase the cost of its
liabilities.
3.2.1. Liquidity Management and the Role of Reserves

Liquidity management refers to the process by which a bank ensures that it has enough liquid
(cash or easily convertible) assets to meet its short-term obligations, such as customer
withdrawals, loan demands, or payment settlements. In simple terms, liquidity means “cash
availability when needed.”

Liquidity, or the ability to fund increases in assets and meet obligations as they come due, is
crucial to the ongoing viability of any banking organization. Therefore, managing liquidity is
among the most important activities conducted by banks. Sound liquidity management can
reduce the probability of serious problems. Indeed, the importance of liquidity transcends the
individual bank, since a liquidity shortfall at a single institution can have system-wide
repercussion. For this reason, the analysis of liquidity requires bank management not only to
measure the liquidity position of the bank on an ongoing basis but also to examine how funding
requirements are likely to evolve under various scenarios, including adverse conditions.

What are the principal sources of liquidity demand for a financial firm?

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The utmost demands for liquidity arise principally from customers withdrawing money from
their deposits and from credit requests. However, demands for liquidity can also come from
paying off previous borrowings, operating expenses and taxes incurred during operations and
from payment of a cash dividend to stockholders also.
What are the principal sources from which the supply of liquidity comes?
Supplies of funds stem principally from incoming deposits, sales of assets, particularly
marketable securities and repayments of outstanding loans. Liquidity also comes from the sale of
non-deposit like remittance fee, bank counter guarantee fee services and borrowings from the
money market.
Importance of liquidity management
1. Meeting Withdrawals:
o Banks must always be ready to repay depositors who wish to withdraw their money.
o Proper liquidity management ensures funds are available without delay.
2. Maintaining Customer Confidence:
o If a bank cannot meet withdrawals, customers lose trust, which may lead to a bank run.
o Adequate liquidity protects the bank’s reputation.
3. Compliance with Central Bank Requirements:
o Central banks require banks to maintain a minimum reserve ratio to ensure liquidity.
o For example, keeping a portion of deposits as cash reserves with the central bank.
4. Smooth Daily Operations:
o Liquidity allows banks to settle interbank payments and fund transfers smoothly.
5. Balancing Profitability and Safety:
o Too much liquidity = low profit (idle cash).
o Too little liquidity = high risk (cash shortage).
o Management must maintain an optimal balance.

3.2.2. Asset Management

Asset management is the process by which a bank manages its use of funds (loans, investments,
reserves) to earn income while maintaining liquidity and minimizing risk. In simple words, it
means deciding how to use bank funds safely and profitably.
Asset management refers to systematic approach to the governance and realization of value from
the things that a group or entity is responsible for, over their whole life cycles. It may apply both
to tangible assets (physical objects such as buildings or equipment) and to intangible assets (such
as human capital, intellectual property, goodwill and/or financial assets). Asset management is a
systematic process of developing, operating, maintaining, upgrading, and disposing of assets in
the most cost-effective manner (including all costs, risks and performance attributes).
The term is commonly used in the financial sector to describe people and companies who
manage investments on behalf of others. Those include, for example, investment managers that
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manage the assets of a pension fund. It is also increasingly used in both the business world and
public infrastructure sectors to ensure a coordinated approach to the optimization of costs, risks,
service/performance and sustainability.
The most common usage of the term "asset manager" refers to investment management, the
sector of the financial services industry that manages investment funds and segregated client
accounts. Asset management is part of a financial company which employs experts who manage
money and handle the investments of clients. From studying the client's assets to planning and
looking after the investments, all things are looked after by the asset managers and
recommendations are provided based on the financial health of each client.
Importance of Asset management
1. Ensuring Profitability:
o Banks earn most of their income from interest on loans and investments.
o Good asset management ensures funds are invested where returns are high but
risks are acceptable.
2. Maintaining Liquidity:
o Some assets (like Treasury bills) are highly liquid and can be sold quickly to meet
cash needs.
3. Risk Management:
o Diversifying loans and investments reduces the risk of default.
o Banks avoid lending too much to one borrower or sector.
4. Credit Quality Control:
o Proper screening and monitoring of borrowers ensure that loans are repaid.
o Reduces non-performing loans (NPLs).
5. Compliance with Regulations:
o Asset allocation must meet regulatory requirements, such as limits on risky
investments.

3.2.3. Liability Management

Liabilities are either the deposits of customers or money that banks borrow from other sources to
use to fund assets that earn revenue. Deposits are like debt in that it is money that the banks owe
to the customer but they differ from debt in that the addition or withdrawal of money is at the
discretion of the depositor rather than dictated by contract.
Liability management refers to how a bank manages its sources of funds mainly deposits and
borrowings to ensure it has adequate and affordable funding for its operations. It is the
management of where and how the bank gets its money.
Liability management is the practice by banks of maintaining a balance between the maturities of
their assets and their liabilities in order to maintain liquidity and to facilitate lending while also
maintaining healthy balance sheets.
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Liability management is the practice by banks of maintaining a balance between the maturities of
their assets and their liabilities in order to maintain liquidity and to facilitate lending while also
maintaining healthy balance sheets. In this context, liabilities include depositors’ money as well
as funds borrowed from other financial institutions. A bank practicing liability management
looks after these funds and also hedges against changes in interest rates.
Importance of Liability Management
1. Ensuring Adequate Funding:
o Banks must always have enough funds to finance loans, investments, and
operations.
o Liability management ensures continuous access to funds.
2. Reducing Cost of Funds:
o By managing interest rates and choosing the right mix of deposits and
borrowings, banks minimize funding costs.
3. Flexibility in Funding Sources:
o Modern banks borrow from interbank markets or issue certificates of deposit and
bonds, not just rely on customer deposits.
4. Maintaining Liquidity:
o Proper liability planning ensures the bank can always raise funds when needed.
5. Supporting Asset Growth:
o As the bank expands its loans and investments, it needs more liabilities (sources
of funds) to support that growth.

3.2.4 Capital Adequacy Management

Capital adequacy management is the process of ensuring that a bank maintains enough capital
(owner’s funds) to absorb potential losses, protect depositors, and comply with regulatory
requirements (such as Basel standards). Capital adequacy management is a bank’s decision about
the amount of capital it should maintain and then acquisition of the needed capital. National
regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and
complies with statutory Capital requirements.
Capital = Bank’s own funds (shareholders’ equity + retained earnings).
Importance of capital adequacy management
1. Protects Against Losses:
o Acts as a financial cushion when loan losses or market shocks occur.
o Prevents insolvency (bank failure).
2. Maintains Solvency and Stability:
o Adequate capital ensures the bank’s assets exceed its liabilities.
o Protects depositors and creditors.
3. Regulatory Compliance:
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o Central banks and the Basel Committee on Banking Supervision (BCBS) require
a minimum Capital Adequacy Ratio (CAR).
o Ensures banks are not overleveraged (taking too much risk).
4. Builds Public Confidence:
o Strong capital signals financial strength and reliability.
o Encourages customers and investors to trust the bank.
5. Supports Growth and Lending:
o More capital allows the bank to expand its assets (like loans) safely.

3.3 Strategies for Managing Bank Capital

Bank capital is the owner’s equity in the bank the funds contributed by shareholders plus
retained earnings. It acts as a financial cushion to absorb losses and protect depositors, ensuring
the bank’s solvency and stability. Managing bank capital means maintaining the right amount
and structure of capital that:
 Meets regulatory requirements,
 Supports business growth, and
 Provides adequate protection against risks.
Bank Capital = Shareholders’ Funds + Retained Earnings. It represents the portion of bank
financing that does not have to be repaid (unlike deposits or borrowings). Bank capital is the
difference between total assets and total liabilities.
It is what the bank “owns” after paying what it “owes.”

Bank management uses three broad strategies:

A. Raising (Increasing) Bank Capital
When capital levels are low or when banks plan to expand, they can raise additional capital.
1. Retaining Earnings (Internal Growth):
 The bank may keep a portion of its profits instead of paying them out as dividends.
 This gradually builds up capital reserves.
 Advantage: No dilution of ownership.
 Disadvantage: Slower method of capital growth.
2. Issuing New Shares (Equity Financing):
 Selling new shares to investors raises fresh equity capital.
 Advantage: Permanent capital, strengthens solvency.
 Disadvantage: Dilutes existing shareholders’ control and may reduce earnings per share.
3. Mergers and Acquisitions:
 Merging with or acquiring another bank can increase total capital base and improve
financial strength.

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B. Reducing the Need for Capital

Sometimes it is not possible or desirable to raise more capital. Instead, banks can reduce their
capital requirements by managing their assets and risks.
1. Improving Asset Quality:
 Reducing non-performing loans (NPLs) lowers risk-weighted assets.
 Better-quality loans mean less capital required to absorb potential losses.
2. Reducing Risk-Weighted Assets (RWAs):
 Shifting investments toward low-risk assets, such as government securities, reduces total
risk exposure and required capital.
3. Asset Securitization:
 Selling off or packaging loans into marketable securities transfers credit risk to investors.
 Frees up capital that was tied to risky assets.
4. Restricting Asset Growth:
 Slowing down new lending or expansion reduces the need for additional capital.
5. Off-Balance Sheet Activities:
 Using fee-based services (like guarantees, letters of credit, and foreign exchange) to
generate income without increasing balance sheet size.
C. Optimizing Capital Structure
Managing capital is not only about increasing or reducing it but also about maintaining the right
mix between equity and debt.
1. Balancing Safety and Profitability:
 High equity = safe but less profitable (since equity is costly).
 High debt = risky but may improve returns.
 The bank must find the optimal capital ratio to satisfy both regulators and shareholders.
2. Maintaining Regulatory Ratios:
 Banks must constantly monitor their CAR, Tier 1, and Tier 2 ratios to remain compliant.
3. Scenario Planning and Stress Testing:
 Simulating economic downturns or credit shocks to determine how much capital is
needed for resilience.
4. Dividend Policy Management:
 Reducing dividend payments during tough periods to conserve capital.
 Increasing payouts during strong profitability to reward shareholders

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