Lecture 3

Banking and the Management of Financial Institutions

Reading: Mishkin, Chapter 10

financial intstitutions
Lecture 3: Banking and the management of
Questions and problems: Chapter 10, problems 1-7, 9, 10, 13

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The Bank Balance Sheet

• Assets
• Reserves: Deposits with the Central Bank + vault cash
-- Required reserves + excess reserves
• Cash items in process of collection: Involving funds from checks or
other payments not yet collected

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Lecture 3: Banking and the management of
• Deposits at other banks: Usually small banks hold them at larger
ones from which they seek a number of services
-- They shrink over time

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The Bank Balance Sheet
• Assets
• Securities: Debt instruments for commercial banks that generate
10% of banks’ revenue
-- Government securities
-- Other securities (from corporations)

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Lecture 3: Banking and the management of
• Loans: Main profitable bank asset that generates more than half
of bank revenues
-- A liability fro the borrower, an asset for the bank
-- Less liquid, they bare high credit risk
• Other assets: Mainly physical capital

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 The Bank Balance Sheet
• Liabilities
• Checkable deposits: Bank accounts that allow their owners to write checks.
-- Shrink over time given the appearance of more attractive financial
instruments
• Non-transaction deposits: Primary source of bank funds

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Lecture 3: Banking and the management of
-- Bear higher interest than checkable deposits
-- Distinguished between savings accounts and time deposits
• Borrowings (31% of bank liabilities): Funds obtained from the Central Bank
and other banks and corporations
-- Discount loans obtained from the CB with an interest rate
-- Reserves borrowed overnight in the CB market to have enough
deposits to meet the reserve requirement
-- Other borrowings from parent companies, other banks, financial
institutions and corporations 4
The Bank Balance Sheet
• Liabilities
• Bank Capital: This is the bank’s net worth, the difference
between total assets and total liabilities
-- Bank capital is raised by issuing new equity (stocks) and from
retained earnings (the portion of net income retained by

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Lecture 3: Banking and the management of
the bank and not distributed to stockholders as dividends
-- It acts as a safety net for the bank against insolvency (having
higher liabilities than assets implies that the bank can be
liquidated
-- Along with risky assets, the main element of banking
regulation

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Table 1 Balance Sheet of All Commercial Banks
(items as a percentage of the total, December 2008)

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Lecture 3: Banking and the management of
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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

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Lecture 3: Banking and the management of
• 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: Check Deposit

First National Bank

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

financial intstitutions
Lecture 3: Banking and the management of
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

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Lecture 3: Banking and the management of
reserves

• Asset transformation: selling liabilities with one set of characteristics and

using the proceeds to buy assets with a different set of characteristics
• The bank borrows short and lends long and makes a profit through the
higher interest rate charged on loans compared to the interest rate paid on
checkable deposits (interest rate margin)
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Bank Management

• Liquidity Management and Risk

• Asset Management
• Liability Management
• Capital Adequacy Management

financial intstitutions
Lecture 3: Banking and the management of
• Credit Risk
• Interest-rate Risk

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Liquidity Management and Risk:
Ample Excess Reserves

Assets Liabilities Assets Liabilities

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

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Lecture 3: Banking and the management of
Capital Capital
Securities $10M Securities $10M

• Suppose 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 Risk:
Shortfall in Reserves

Assets Liabilities Assets Liabilities

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

financial intstitutions
Lecture 3: Banking and the management of
Capital Capital
Securities $10M Securities $10M

• Reserves are a legal requirement and the shortfall must be

eliminated (the bank should now have 10% of 90M = 9M
Reserves
• Excess reserves are insurance against the costs associated with
deposit outflows 12
Liquidity Management and Risk:
Borrowing

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M

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Securities $10M Bank Capital $10M

• Bank has four options

• To borrow from the CB at the overnight market or from other banks and
the cost incurred is the interest rate paid on the borrowed funds

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Liquidity Management: Securities Sale

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

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Lecture 3: Banking and the management of
Securities $1M

• Second option is to sell securities: The cost of selling securities is

the brokerage and other transaction costs

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Liquidity Management: Central Bank

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from the CB $9M

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Lecture 3: Banking and the management of
Securities $10M Bank Capital $10M

• Third option is to borrow from the Central Bank at the discount

window, which also incurs interest payments based on the
discount rate

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Liquidity Management: Reduce Loans

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

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Lecture 3: Banking and the management of
Securities $10M

• Fourth way is the reduction of loans, which 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 16
Asset Management: Three Goals

• Seek the highest possible returns on loans and securities

• Reduce risk
• Have adequate liquidity

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Asset Management: Four Tools

• Find borrowers who will pay high interest rates and have low
possibility of defaulting
• Purchase securities with high returns and low risk
• Lower risk by diversifying

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Lecture 3: Banking and the management of
• Balance need for liquidity against increased returns from less liquid
assets

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Liability Management

• Recent phenomenon due to rise of money center banks (large key

banks in large financial centers)
• Expansion of overnight loan markets and new financial instruments
(such as negotiable Certificates of Deposits, CDs)

financial intstitutions
Lecture 3: Banking and the management of
• Checkable deposits have decreased in importance as source of bank
funds
• For example, when a bank finds an attractive loan opportunity it can
acquire funds by selling a negotiable CD or by borrowing in the
interbank or overnight market

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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 for bank capital has become the most

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important regulatory tool

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Capital Adequacy Management: Preventing
Bank Failure
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M

High Bank Capital Low Bank Capital

financial intstitutions
Lecture 3: Banking and the management of
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

• 5M worth of loans from both banks go bad

• The low capital bank is insolvent as it does not have sufficient assets
to pay off all holders of its liabilities
• This either leads to a liquidation or to an acquisition from another
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healthy bank
Capital Adequacy
Management:
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

financial intstitutions
Lecture 3: Banking and the management of
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
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ROE = ROA  EM
Capital Adequacy Management: Safety

• 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

financial intstitutions
Lecture 3: Banking and the management of
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Application: How a Capital Crunch Caused a
Credit Crunch in 2008

• Shortfalls of bank capital led to slower credit growth

• Huge losses for banks from their holdings of securities backed by
residential mortgages.
• Losses reduced bank capital
• Banks could not raise much capital on a weak economy, and had to

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Lecture 3: Banking and the management of
tighten their lending standards and reduce lending.

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Credit Risk: Overcoming
Adverse Selection and Moral
Hazard
• Credit risk: The risk inherent in bank assets
(non-repayment from debt holders—
borrowers)

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Lecture 3: Banking and the management of
• Screening and Monitoring
• Screening
• Specialization in lending
• Monitoring and enforcement of
restrictive covenants 25
Credit Risk: Overcoming Adverse Selection
and Moral Hazard
• Long-term customer relationships
• Quality information about customers
• Also benefit the customers
• The borrower can reduce moral hazard incentives to keep obtaining
low interest rates

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Lecture 3: Banking and the management of
• Loan commitments
• A written commitment to provide credit up to a given amount

• Collateral and compensating balances

• Compensation in case of loan default

• Credit rationing
• Through refusal to make the loan or restrictions on the size of the loan 26
Interest-Rate Risk
• The risk originating from the volatility of interest
rates
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M

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Lecture 3: Banking and the management of
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital

• 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 27
• This of course assumes the same interest on both the asset and the liability side, which is not the case in modern
banking
Interest Rate Risk: Gap Analysis

• Basic gap analysis:

(rate sensitive assets - rate sensitive liabilities) x Δ in interest rates = in
bank profit
• Maturity backed approach

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Lecture 3: Banking and the management of
• Measures the gap for several maturity subintervals.
• Standardized gap analysis
• Accounts for different degrees of rate sensitivity.

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 Interest Rate Risk: Duration Analysis

Δ % 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

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Lecture 3: Banking and the management of
change in interest rates.

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Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)

• Selling loans at a higher rate than the loan amount, but lower than the
loan amount + interest so that others are willing to buy them
• These loans are not assets any more

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Lecture 3: Banking and the management of
• Generation of fee income. Examples:
• Servicing mortgage-backed securities through securitization
• Creating SIVs (structured investment vehicles) which can potentially
expose banks to risk, because when they severely decline in value the
bank might have to acquire them bank, as it happened in the
subprime financial crisis of 2007-2008.

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Off-Balance-Sheet Activities
• Trading activities and risk management techniques
• Financial futures, options for debt instruments, interest rate swaps,
transactions in the foreign exchange market and speculation.
• Principal-agent problem arises. If bank managers and traders follow
their own strategies, seeking to maximize their bonuses.

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Off-Balance-Sheet Activities

• Internal controls to reduce the principal-agent problem

• Separation of trading activities and bookkeeping so that traders do
not know the bank’s profit position
• Limits on exposure

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Lecture 3: Banking and the management of
• Value-at-risk
• Stress testing

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