Ch 9: General Principles of Bank Management

1. . ". 4. 1. 2. 3.

How the bank manages its assets and liabilities to earn the highest possible profits? The manager of the bank has 4 primary concerns: Liquidity management. !sset management. Liability management. #apital adequacy management. Liquidity management and the role of reser$e: How the bank deals with deposit outflows? This is when deposits are lost because depositors make withdrawals and demand payment.
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Example: -RRR (10 !" Bank #$E initial %alance sheet:

&ssets Reser(es (RR)10"ER)10!*0 'oans ,0 -ec.rities 10 'ia%ilities +eposits Capital 100 10

/he re0.ire1 reser(e is (10!" %.t total reser(es ) (*0!" therefore" the %ank has excess reser(es ) (10!

2f a 1eposit o.tflo3 of (10! occ.rs" the %ank s %alance sheet %ecomes: &ssets Reser(es (RR)9"ER)1! 10 'oans ,0 -ec.rities 10 'ia%ilities +eposits Capital 90 10

/he %ank loses (10! of 1eposits &$+ (10! of reser(es4 B.t since the total amo.nt of 1eposits ) (90!" an1 RRR ) (10 !" Re0.ire1 reser(e ) (9!" an1 Excess reser(e )(1! 2f the %ank has excess reser(es" a 1eposits) o.tflo3 1oes not necessitate changes in other parts of its %alance sheet4
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B.t 3hat if the %ank hol1s ins.fficient excess reser(es5 Example: /he %ank hol1s no excess reser(es: Bank #$E &ssets 'ia%ilities RR 10 +eposits 100 'oans 90 capital 10 -ec.rities 10

/he re0.ire1 reser(e is (10!" an1 total reser(es ) (10!" therefore" the %ank hol1s no excess reser(es ) ER ) (0!
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2f (10! 1eposit o.tflo3 occ.rs: 'ia%ilities +eposits Capital

&ssets RR -9 'oans 90 -ec.rities 10

90 10

/here is a 1ecline in 1eposits an1 reser(es %6 (10! /he reser(es ) (0!" this is a pro%lem since the re0.ire1 reser(e m.st ) (9: 10 790! /he %ank has $# RE-ER8E9
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/o eliminate this pro%lem" the %ank has : options: 14 Borro3ing from other %anks (;E+!" or %orro3ing from corporation4 /he %anks %alance sheet %ecomes:

&ssets Reser(es 9 'oans 90 -ec.rities10

'ia%ilities +eposits 90 Borro3ing from other %anks or corp4 9 Capital 10 Pa6s interest ) ;e1eral ;.n1 Rate
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*4 -ell sec.rities: -ell sec.rities 3orth (9!" the %alance sheet %ecomes: &ssets 'ia%ilities Reser(es9 +eposits 90 'oans 90 Capital10 -ec.rities 1 Cost) 'i0.i1ation" %rokerage
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<4 Borro3ing from the ;e1: &ssets Reser(es9 'oans 90 -ec.rities 10 'ia%ilities +eposits 90 +isco.nt loans from the ;e1 10 Capital 10

Pa6s interest ) +isco.nt rate4

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:4 Calling in or selling loans: Re1.cing its loans %6 (9! an1 1epositing the (9!: &ssets 'ia%ilities Reser(es9 +eposits90 'oans,1 Capital 10 -ec.rities 10 /his sol.tion is costl6: Ma6 not %e a%le to rene3 loans of some clients -ell loans at lo3er (al.es
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/his sho3s 3h6 a %ank hol1s excess reser(es tho.gh reser(es pa6 no interest: to face 1eposits o.tflo34 Excess reser(es are ins.rance against the cost associate1 3ith 1eposits o.tflo3s4 /he higher the costs associate1 3ith 1eposit o.tflo3s" the more excess reser(es %ank 3ill 3ant to hol14
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&sset Management.2
=hen managing its assets (to maximi>e profits!" the %ank m.st: &-eek the highest ret.rns on loans an1 sec.rities" BRe1.ce risk" C Eno.gh pro(isions for li0.i1it6 (hol1ing li0.i1 assets!4
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/o accomplish these goals" fo.r %asic 3a6s: 1- ;in1 %orro3ers 3ho 3ill pa6 high interest rates %.t .nlikel6 to 1efa.lt (-creening to re1.ce a1(erse selection pro%lem!4 *- P.rchase sec.rities 3ith high ret.rns an1 lo3 risk4 <- +i(ersification of assets: p.rchase 1ifferent t6pe of assets" 1i(ersif6 %orro3ers4 :- Manage li0.i1it6 to satisf6 reser(es re0.irements4

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<- 'ia%ilit6 Management

/he .se of lia%ilities in the creation of reser(es an1 li0.i1it6 (&ssets!: Before: $o interest pai1 on checka%le 1eposits" therefore" no competition for 1eposits %et3een %anks4 Banks rarel6 .se1 o(ernight loans

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&fter: Expansion of o(ernight loans +e(elopment of ne3 financial instr.ments /he flexi%ilit6 in lia%ilit6 management means: the %ank nee1 not to 1epen1 on checka%le 1eposits as the primar6 so.rce of f.n1s (lia%ilities!4
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:- Capital &1e0.ac6 Management

Capital) Banks net 3orth ) /otal assets /otal lia%ilities Maintaining the appropriate capital (net 3orth! to pre(ent %ank fail.re" maintain o3ners ret.rns" an1 meet central %ank reg.lations4

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1- Pre(ent Bank ;ail.re:

Example (1!: Consi1er t3o %anks" one 3ith capital to assets ratio of 10 other 3ith : 4 ?igh Capital Bank &ssets 'ia%ilities Reser(es 10 +eposits 90 'oans 90 Bank Capital 10 'o3 Capital Bank &ssets Reser(es 10 'oans90

an1 the

'ia%ilities +eposits 9@ Bank Capital :

2f the t3o %anks lose A million of their loans" their assets an1 capital17 3ill 1ecline too %6 the same amo.nt4

/he ne3 %alance sheets %ecome as follo3s:

?igh Capital Bank &ssets Reser(es 10 'oans ,A 'ia%ilities +eposits 90 Bank Capital A

'o3 Capital Bank &ssets 'ia%ilities Reser(es 10 +eposits 9@ 'oans,A Bank Capital -1 /he high capital %ank is still in a goo1 sit.ation %eca.se its net 3orth (capital! is still positi(e (BA million!4
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/he lo3 capital %ank is in a %a1 sit.ation %eca.se its net 3orth is negati(e (-B1 million! /he (al.e of its assets is less than its lia%ilities" therefore it is insol(ent (%ankr.pt!: 2t 1oes not ha(e eno.gh assets to pa6 off hol1ers of its lia%ilities (cre1itors!4 =hen a %ank %ecomes insol(ent" the go(ernment closes it4
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*-Bank Capital &ffects Ret.rns to E0.it6 ?ol1ers:

Bank o3ners nee1 meas.res of %ank profita%ilit6 to kno3 if the %ank is manage1 3ell or not: &4 Ret.rn on &ssets (R#&!: R#& ) $et profit after taxes C &ssets /he R#& sho3s ho3 efficientl6 a %ank is %eing r.n %6 in1icating ho3 m.ch profits are generate1 on a(erage %6 each 1ollar of assets4

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B4 Ret.rn on E0.it6 (R#E!: R#E ) net profit after taxes C e0.it6 capital /he R#E sho3s ho3 m.ch the %ank earns on e0.it6 in(estment4

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C4 E0.it6 M.ltiplier (EM!: EM ) assets C e0.it6 capital 2t is the amo.nt of assets per 1ollar of e0.it6 capital4 2t sho3s the 1irect relationship %et3een R#& an1 R#E: $et profit after taxes C E0.it6 capital ) (net profit after taxes C assets! D (assets C e0.it6 capital! R#E ) (R#&! D (EM!

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R#E ) (R#&! D (EM!

/his form.la sho3 3hat happens to the ret.rn on e0.it6 3hen a %ank hol1s a smaller amo.nt of capital (e0.it6! for a gi(en amo.nt of assets4

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Example
Thehighcapitalban ha!anE"#10 $100%10&#10 Thel'(capitalban ha!anE"#25 $100%4&#25 )*+,-i!1./then0 +,E*'1thehighcapitalban #1.210 #10. +,E*'1thel'(capitalban #1.225# 25.
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 E34it5h'l6e1!'*thel'(capitalban a1e happie1beca4!ethe5ha7ea1et41nt(ice highe1.

Th4!/ban '(ne1!6'n8tli eh'l6ingal't '*capital$beca4!eit1e64ce!+,E$

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Res.lt: Gi(en the R#&" the lo3er the %ank capital" the higher the R#E4 /his sho3 that there is a tra1e-off %et3een safet6 an1 ret.rns4 /ra1eoff: ?igh %ank capital re1.ces possi%ilit6 of %ankr.ptc6" %.t lo3ers (R#E!
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<- Bank Capital Re0.irements:

Banks hol1 capital %eca.se the6 are re0.ire1 %6 la3 to 1o so4

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 14 *4 <4 :4 A4

Managing Cre1it Risk /he %ank m.st make goo1 loans that are pai1 %ack ($o 1efa.lt! -creening an1 Monitoring" 'ong-/erm C.stomer Relation 'oan commitments Collateral an1 Compensating Balances Cre1it rationing
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-creening an1 the pro%lem of &1(erse -election in loan market:

=hen %a1 cre1it risk (most likel6 to 1efa.lt! are the ones 3ho tr6 to get loans4 2n(estors 3ith risk6 assets are the most eager to o%tain loans" %.t are the least 1esira%le %orro3ers4 M.st collect information a%o.t potential %orro3ers4

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Moral ?a>ar1 in loan market:

%orro3ers ma6 engage in .n1esira%le acti(ities from the len1ers point of (ie34

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Managing 2nterest-Rate Risk

?igh (olatilit6 in interest rates makes %anks expose1 to interest- rate risk: /he risk of earnings an1 ret.rns that is associate1 3ith changes in interest rates4

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Example: ;irst $ational Bank &ssets 'ia%ilities Rate-sensiti(e &ssets Rate-sensiti(e 'ia%ilities ;ixe1 -rate &ssets ;ixe1-rate 'ia%ilities B *0 million of assets are rate sensiti(e" 3hile B,0 million 3ith fixe1 rates4 B A0 million of lia%ilities are rate sensiti(e" 3hile B A0 million 3ith fixe1 rates4

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2f interest rate rises from 10 to 1A (E A !: income on assets rises %6 B1 million: E in income ) E in interest D rate sensiti(e assets ) A D B *0 million ) B 1 million pa6ments on lia%ilities rise %6 B*4A million: E in cost of lia%ilities ) E in interest D rate sensiti(e lia%ilities )A D B A0 million ) B *4A million /he %ank profitFs 1ecline %6 B14A million (B1 - B*4A!

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?o3e(er" if interest rate falls %6 A " profit rises %6 B14A million4 Res.lt: 2f a %ank has more rate-sensiti(e lia%ilities than assets" a rise in interest rates re1.ces %ank profits" 3hile a 1ecline in interest rates raises profits4

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Gap and Duration Analysis:

1- Gap &nal6sis: /he sensiti(it6 of %ank profits to changes in interest rates can %e meas.re1 1irectl6 .sing gap anal6sis %6: (Rate sensiti(e &ssets - Rate sensiti(e lia%ilities! 2n the example a%o(e" the gap e0.als B<0 million (B*0 - BA0!

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B6 m.ltipl6ing the change in interest rate %6 the gap" 3e o%tain the effect on profits:

E in profit ) A D - B<0 million ) - B14A million4

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+.ration &nal6sis- 2

&n alternati(e meas.re of interest rate risk is duration analysis" 3hich examines the sensiti(it6 of the market (al.e of the %ankFs total assets an1 lia%ilities to changes in interest rates4

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+.ration anal6sis .ses the a(erage 1.ration of assets an1 lia%ilities to see ho3 the net worth respon1s to a change in interest rates4

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/o meas.re the effect of %ankFs net 3orth 1.e to a change in interest rate: E in market (al.e) (% E in interest rate x +.ration! +o the same so &-'

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2n the example a%o(e" if a(erage 1.ration of assets is three 6ears an1 lia%ilities is t3o 6ears" assets are B100 million" an1 lia%ilities are B90 million4

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2f interest rate rises %6 A : 8al.e of assets falls %6 1A (- A D < 6ears!-" or B1A million4 8al.e of lia%ilities falls %6 10 (-A D * 6ears!" or B9 million4
#r: (-A D < D 100! - (-A ) -1A G 9 ) -@9 D * D 9!
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$et 3orth falls %6 B @ million" or @ of assets4 ?o3e(er" a A 1ecline in interest rates increases net 3orth %6 @ (of total assets! Can 6o. sho3 ho35

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#ff-Balance--heet &cti(ities

/his in(ol(e acti(ities that affect %ank profits" %.t 1o not appear on the %anks %alance sheet4 /ra1ing financial instr.ments an1 generating income from fees an1 loan sales4

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1- 'oan -ales (-econ1ar6 'oan Participation!: & contract that sells all or part of the cash stream of a loan therefore" it remo(es the loan from the %anks %alance sheet4 *- Generation of ;ee 2ncome: Earne1 from pro(i1ing speciali>e1 ser(ices to c.stomers: foreign exchange tra1e" mortgage %acke1 sec.rit6" %ankers acceptance
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<- /ra1ing &cti(ities an1 Risk management /echni0.es:

2nternational Banking /ra1ing in financial markets -pec.lations Risk6 acti(ities: 2nsol(enc64

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