Lecture 11: The Banking Firm & Bank Management

Introduction

Banks (depository institutions), the most important of all financial intermediaries, play a major role in
channeling funds to borrowers with productive opportunities. Banks are financial institutions that accept
money deposits and make loans. They are also important in ensuring the financial system and economy run
smoothly and efficiently. They play an important role in determining the money supply and in transmitting
the effects of monetary policy to the economy, which is known as multiple deposit creation. They have been
also a source of the rapid financial innovation.

The Bank Balance Sheet

Balance sheet is a list of the assets and liabilities of a bank (or firm) that balances:
Total assets = Liabilities + Capital. Liabilities = sources of bank funds
Assets = uses of bank funds
Balance Sheet (T-account)
Assets Liabilities
Reserves Checkable deposits
Cash items in process of collection Non-transaction deposits
Deposits at other banks Borrowings
Securities Bank Capital
Loans
Other Assets (e.g. physical capital)

Assets
Reserves
• deposits + currency that is physically held by banks.
• Required reserves: Reserves that are held to meet the central bank requirement that for every dollar of
deposits at bank, a certain fraction must be kept as reserves.
• Required reserves ratio = required reserves/deposits
• Excess reserves: Reserves in excess of required reserves.
Cash Items in Process of Collection
• Deposits at Other Banks: Many small banks hold deposits in larger banks in exchange for a variety of
services including check collection, foreign exchange transactions, and help with securities purchases.
Securities
• T-bills and longer-term government bonds. These kinds of bonds are called secondary reserves.
Loans
• Banks make their profits primarily by issuing loans.
• (i) Commercial and industrial; (ii) Real estate, residential mortgage; (iii) Consumer; (iv) Inter-bank
Other Assets
• The physical capital (buildings, pens, other equipment…) owned by the banks is included in this category.
(1 and 2 are cash)ppp
Liabilities
Checkable deposits
• Checkable deposits include all accounts on which checks can be drawn.
• Checkable deposits are payable on demand; that is, if a depositor shows up at the bank and requests
payment by making a withdrawal, the bank must pay the depositor immediately.
• Checkable deposits are usually the lowest-cost source of bank funds as interest rates are low.

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Non-transaction Deposits (primary source of funds)
• Saving deposits (common)
• Small-denomination time deposits & Large-denomination time deposits (fixed maturity length)((HigherCost)
• Owners cannot write checks on non-transaction deposits, but their interest rates are usually higher than
those on checkable deposits.
Borrowings
• Banks obtain funds by borrowing from the central bank, other banks, and corporations.
Bank Capital
• Bank Capitals (Bank’s Net Worth) = Total assets – Total Liabilities

Basic Operation of a Bank

Banks make profits by selling liabilities with one set of characteristics (a particular combination of liquidity,
risk, and return) and using the proceeds to buy assets with different set of characteristics. This process is
called asset transformation. (lending long and borrowing short). For example, the bank has transformed the
savings deposit (an asset held by the depositor) into a loan (an asset held by the bank).
Using T-account (a simplified balance sheet) for analysis:
Case 1: Mr. A opens a checkable or current account with cash deposit ($100) at the First National Bank
(FNB).
FNB
Assets Liabilities
Vault Cash +$100 Checkable deposits +$100
Assets Liabilities
Reserves +$100 Checkable deposits +$100
Case 2: Mr. A opens the same account by issuing a check on an account at another bank instead.
FNB
Assets Liabilities
Cash item in process +$100 Checkable deposits +$100
of collection
Assets Liabilities
Reserves +$100 Checkable deposits +$100
When a bank reserves additional deposits, it gains an equal amount of reserves.
Suppose the required reserves ratio = 10%, the FNB’s T-account is rewritten as follows:
FNB
Assets Liabilities
Required reserves +$10 Checkable deposits +$100
Excess reserves +$90
Reserves pay no interest. The bank is making loan instead of holding excess reserves.
FNB
Assets Liabilities
Required reserves +$10 Checkable deposits +$100
Loan +$90
The bank is making a profit because it holds short-term liabilities such as checkable deposits and
uses the proceeds to buy longer-term assets such as loans with higher interest rates.

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General Principles of Bank Management

The bank management team has 4 primary concerns: (i) Liquidity Management; (ii) Asset Management; (iii)
Liability Management; (iv) Managing Capital Adequacy.

Liquidity Management
A bank’s liabilities include all the banks sources of funds. The amounts and sources of funds clearly affect
how much liquidity risk a bank has and how much liquidity it can create. The easier a bank can access funds
the less risk it has and the higher amount of funds it holds the more liquidity it can create. The acquisition of
sufficiently liquid assets is necessary to meet the bank’s obligations to depositor (deposit outflows). For
example, the bank has ample excess reserves more than the required reserve ratio, says, 10%.
Initial balance sheet
FNB
Assets Liabilities
Reserves $20 Deposits $100
Loans $80 Bank capital $10
Securities $10
Since required reserves = $10, then excess reserves = $10.
If a deposit outflow of $10 occurs, the bank’s balance sheet becomes:
Assets Liabilities
Reserves $10 Deposits $90
Loans $80 Bank capital $10
Securities $10
Now required reserves = $9 and excess reserves = $1.
If a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.
But banks do not like to hold excess reserves because excess reserves do not generate any income!
Consider the following balance sheet:
Assets Liabilities
Reserves $10 Deposits $100
Loans $90 Bank capital $10
Securities $10
Now deposit outflow = $10, the bank has four options to meet this outflow with different costs.
1. Borrowings from other banks or corporation
Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Borrowings from other banks $9
Securities $10 Bank capital $10
Cost = interest rate on these loans.
2. Selling Securities
Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Bank capital $10
Securities $1
Cost = some brokerage and other transaction costs when the bank sells these securities.

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3. Borrowing from the central bank
Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Loans from the central bank $9
Securities $10 Bank capital $10
Explicit cost = interest rate on these loans.
Implicit cost = increased scrutiny of the bank by authority.
4. Reduce lending
Assets Liabilities
Reserves $9 Deposits $90
Loans $81 Bank capital $10
Securities $10
Cost = losing customers relationship = losing customers = losing business
When a deposit outflow occurs, holding excess reserves allows the bank to escape the costs of (1) borrowings
from other banks or corporations, (2) selling securities, (3) borrowing from the central bank, or (4) calling in
or selling off loans. Excess reserves are insurance against the costs associated with deposit outflows.

Asset Management
To maximize the bank’s profits, a bank must simultaneously (1) seek the highest returns possible on loans and
securities, (2) minimize risk, and (3) make adequate provisions for liquidity by holding liquid assets. Banks
try to accomplish these three goals in four basic ways:
1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans.
2. Banks try to purchase securities (secondary reserves) with high returns and low risk.
3. In managing their assets, banks must try to minimize risk by diversifying.
For example, they purchase different types of bonds (T-bills vs. longer-term government bonds), and
approve many types of loans to a number of customers.
4. The bank must manage the liquidity of its assets so that it can satisfy its reserve requirements without
bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower
return than other assets.

Liability Management
Liabilities includes checkable deposits, saving deposits, time deposits (e.g., CDs) and funds borrowed from
other banks and financial institutions.
A bank can face a mismatch between assets and liabilities because of illiquidity or changes in interest rate.
Liability management is the practice by banks of maintaining a balance between the maturities of their assets
and their liabilities in order to reduces the likelihood of a mismatch, and keep liquidity to facilitate lending
while also maintaining healthy balance sheets.
Starting in 1960s, the bank no longer needed to depend on checkable deposits as the primary source of bank
funds. Banks set target goals for their asset growth and tried to acquire funds (by issuing liabilities) as they
were needed. When a large bank finds an attractive loan opportunity, it can acquire funds by selling a
negotiable CD.

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Managing Capital Adequacy
Banks make decisions about the amount of capital they need to hold for 3 reasons:
1. Regulatory authorities require a minimum amount of bank capital.
2. How Bank Capital helps prevent bank failure?
High Capital Bank
Assets Liabilities
Reserves $10 Deposits $90
Loans $90 Bank Capital $10
Bank capital / Assets = $10 / $100 = 0.1 = 10%
Low Capital Bank
Assets Liabilities
Reserves $10 Deposits $96
Loans $90 Bank Capital $4
Bank capital / Assets = $4 / $100 = 0.04 = 4%
If the real estate market collapses, banks may force to write off their bad loans ($5).
High Capital Bank
Assets Liabilities
Reserves $10 Deposits $90
Loans $85 Bank Capital $5
Low Capital Bank is insolvent now. When a bank becomes insolvent, government regulators may close the
bank. Therefore, a bank maintains bank capital to lessen the chance that it will become insolvent.
Low Capital Bank
Assets Liabilities
Reserves $10 Deposits $96
Loans $85 Bank Capital -$1
3. How does the amount of Bank Capital affect Returns to Equity Holders?
Two measures of bank profitability:
• Return on assets (ROA) = Net profit after taxes / Assets
It measures how efficiently the bank is run.
• Return on equity (ROE) = Net profit after taxes / Equity (Bank) capital
It measures how well the owners are doing on their investment.
A direct relationship between ROA & ROE is called: Equity Multiplier (EM) = Assets / Equity Capital
Hence, we get the formula ROE = ROA x EM
High Capital Bank Low Capital Bank
Assets = $100 Bank Capital = $10 Assets = $100 Bank Capital = $4
EM = $100 $100 = 10 EM = $100 = 25
$10 $4
If ROA1%, ROE10% If ROA1%, ROE25%
Given the ROA, the lower the bank capital, the higher the return for the owners of the bank.
Obviously, High Bank Capital => minimize the chance of insolvency, but also => ROE is lower.

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Managing Credit Risk

In order to earn high profits, banks must make successful loans that are paid back in full. Banks manage or
minimize credit risk; they have to overcome the adverse selection and moral hazard.
Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans)
are the ones who usually line up for loans. In other words, those who are most likely to produce an adverse
outcome are the most likely to be selected. Moral hazard exists in loan markets because borrowers may
have incentives to engage in activities that are undesirable from the lender’s point of view. In such
situations, it is more likely that the lender will be subjected to hazard of default.

Screening and Monitoring

Screening: To undertake effective screening, banks collect reliable information from prospective borrowers
who are asked to provide information about their personal finances. Effective screening and information
collection form an important principle of credit risk management.
Monitoring: To reduce moral hazard after making loan, banks must adhere to the principle for managing
credit risk that a bank should write provisions into loan contracts that restrict borrowers from engaging in
risky activities.
Specialization in Lending: A bank often specializes in lending to local firms or to firms in particular
industries, such as real estate. However, it is not diversifying their portfolio of loans.

Long-term Customer Relationships

If a prospective borrower has had a checking or saving account or other loans with the bank over a long period
of time, the bank can lean from the past activities on the accounts and know more about the potential
borrower. It reduces the costs of information collection and make it easier to screen out bad credit risks.

Loan Commitments
A loan commitment is a bank’s commitment to provide a firm with loans up to a given amount at an interest
rate that is tied to some market interest rate. It promotes long-term relationship. The firm continually
supplies the bank with information about its income, asset and liability position.

Compensating Balances
Compensating balances is a particular form of collateral is required when a bank makes commercial loans is
called compensating balances. It is especially common with corporate loans. A firm receiving a loan must
keep a required minimum amount of funds in a checking account at the bank. It increases the cost of capital
to the borrower and reduces the lending cost for the lender, since the lender can invest the cash placed in the
compensating bank account.

Collateral
The lender can sell collateral and use the proceeds to make up for its losses on the loan.

Credit Rationing
Credit rationing takes two forms:
• A bank lender refuses to make a loan of any amount to a borrower, even though the borrower is willing to
pay the stated interest rate or even a higher rate.
• A bank is willing to make a loan but restricts the size of the loan to less than the borrower would like.

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Managing Interest-rate Risk

The riskiness of earnings and returns is associated with changes in interest rates.
FNB
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
e.g., variable-rate loans, short-term securities e.g., variable-rate CDs
Fixed-rate assets $80M Fixed-rate liabilities $50M
e.g., reserves, long-term loans, long-term securities e.g., checkable deposits, saving deposits

With no transaction costs, suppose that interest rates rise by 5 percentage points, say, on average from 10% to
15%.
Income on the assets : 5%×20M = 1M
Payments on the liabilities : 5%×50M = 2.5M
Bank’s profit : 2.5M – 1M = 1.5M
Similarly, if interest rates decrease from 10% to 5%, bank’s profits  1.5M.
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a
decline in interest rates will raise bank profits.

Basic (Income) Gap Analysis

The sensitivity of bank income or profits to changes in interest rates can be measured more directly using gap
analysis (also called income gap analysis).
GAP = Interest Rate Sensitive Assets (ISA) – Interest Rate Sensitive Liabilities (ISL)
= 20M – 50M = – 30M
If it is positive, it is called positive gap or asset-sensitive gap.
If it is negative, it is called negative gap or liability-sensitive gap.
Profits = i x GAP
For the negative gap: 10% increases to 15%, Bank’s profits = 5%×(-30M) = -1.5M
10% decreases to 5%, Bank’s profit = -5%×(-30M) = 1.5M

Gap management is a technique for protecting a financial institution’s earnings from losses due to changes in
interest rates by matching the volume of ISA held to the volume of ISL taken on. The bank management
team believes that interest rates will fall in the future, they will change the portfolio; they may reduce rate-
sensitive assets, and increase rate-sensitive liabilities.
A negative gap may be a reflection of a bank’s belief that interest rates will fall.
A positive gap may be a reflection of a bank’s belief that interest rates will rise.

Interest-rate Swaps
FNB can swap with SNB to get rid of interest risk for both parties. There is an over-the-counter (OTC)
agreement or contract traded between two parties where one stream of future interest payments is exchanged
for another based on a specified principal amount. An interest-rate swap is a derivative in which one party
exchanges a stream of interest payments for another party's stream of cash flows.
Interest-rate swaps enable a financial institution that has more rate-sensitive assets than rate-sensitive
liabilities to ‘swap’ payment streams with a financial institution that has more rate-sensitive liabilities than
rate-sensitive assets, thereby reducing interest-rate risk for both. They are very popular instruments and can
be used by hedgers to manage their fixed or floating assets and liabilities.

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For example, FNB would like to convert $30M of its fixed-rate assets into $30M of rate-sensitive assets.
FNB
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
(+$30M)
Fixed-rate assets $80M Fixed-rate liabilities $50M
(–$30M)
SNB
Assets Liabilities
Rate-sensitive assets $80M Rate-sensitive liabilities $50M
(–$30M)
Fixed-rate assets $20M Fixed-rate liabilities $50M
(+$30M)

Off-Balance-Sheet Activities

Fee Income
There are many types of income generated specialized services:
• Foreign exchange trades for customers
• Servicing mortgage-backed securities
• Loan Commitment / Guarantees of debt
• Backup lines of credit
•
It involves trading financial instruments and generating income from fees and loan sales, activities that affect
bank profits but do not appear on bank balance sheets, at least, temporarily.

Trading Activities
Financial derivatives such as financial forwards and futures, options, swaps, can help the bank reduce its
interest-rate risk. Banks engaged in international banking also trade in foreign exchange market. These
activities also help bank make profits.

Securitisation and Loan sales (secondary loan participation)

• Securitisation turns illiquid loans or financial assets into liquid assets which are usually marketable capital
market securities. The bank can earn added fee income by the related services.
• Under a loan participation agreement, a bank will sell all or part of the cash stream from a specific loan
and thereby removes the loan from the bank balance sheet.
• Collateralized debt obligations (CDOs) [債務抵押債券] are a type of asset-backed security and structured
credit product such as CLO (Collateralised Loan Obligation) and CBO (Collateralised Bond Obligation).
CDOs gain exposure to the credit of a portfolio of fixed-income assets and divide the credit risk among
different tranches.
• A structured investment vehicle (SIV) is a pool of investment assets that attempts to profit from credit
spreads between short-term debt and long-term structured finance products. An SIV is an entity set up
when a bank buys long-term assets that have less liquidity but pay higher yields and finances them by
issuing short-term commercial paper (CP) that is continuously renewed or rolled over. It is a fixed
income maturity transformation fund, similar to a CDO. The SIVs often employ great amounts of
leverage to generate returns. They are a type of structured credit product; they are usually investing in a
range of asset-backed securities, as well as some financial corporate bonds. Unlike a CDO, an SIV has
an open-ended (or evergreen) structure; it plans to stay in business indefinitely by buying new assets as
the old ones mature.
• It increases risk as the leverage increases.