II.

2 Banking Management

Money, Banking and Financial Markets

A Stylized Balance Sheet of a Bank
Assets Liabilities
Reserves Capital

Financial Assets Deposits

Loans Borrowings

Other assets
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
Deposit withdrawal (Beginning)
Assets Liabilities
20 Reserves Capital 10

80 Loans Deposits 100

10 Financial Assets
Deposit withdrawal (Less Reserves)
Assets Liabilities
10 Reserves Capital 10

80 Loans Deposits 90

10 Financial Assets
Problem: what happens if the bank
does not have enough reserves?
Deposit withdrawal (Beginning)
Assets Liabilities
10 Reserves Capital 10

90 Loans Deposits 100

10 Financial Assets
Deposit withdrawal (Less Reserves)
Assets Liabilities
0 Reserves!! Capital 10

90 Loans Deposits 90

10 Financial Assets
I cannot! I need alternatives
Alternative 1: Borrow (other banks or
Central Bank)
Assets Liabilities
9 Reserves Capital 10

90 Loans Deposits 90

Borrowings 9
10 Financial Assets
Alternative 2: Reduce Financial Assets
Assets Liabilities
9 Reserves Capital 10

90 Loans Deposits 90

1 Financial Assets
Alternative 3: Reduce Loans
Assets Liabilities
9 Reserves Capital 10

81 Loans Deposits 90

10 Financial Assets
Another liquidity problem, very much
related to the recent financial crisis
Balance Sheet (Beginning)
Assets Liabilities
10 Reserves Capital 10

90 Loans Deposits 60

Borrowings 40
10 Financial Assets
Interbank market dries up: borrowing goes down,
what can the bank do?

 Interbank market dries up: borrowing goes down,
what can the bank do?

Very problematic than in a financial crisis!
1. I cannot borrow from other banks
2. Bad time to Sell loans and financial assets: prices are low: firesales: more losses
3. Typically resort to Central Bank borrowings
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
Asset Management: Searching for an
optimal mix between Risk and Return
Borrowers eager to pay high interest rates
Financial assets with high returns
Risk diversification
Maintain sufficient reserves and liquid assets
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
Liabilities: return and flexibility

More intense use of the REPO/CDs market

(certificate of deposit)
Increasing funding via borrowing, and less via
deposits
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
Problem: what happens after
several loan defaults?
Bank 1: with plenty of capital
Assets Liabilities
10 Reserves Capital 10

90 Loans Deposits 90
Bank 2: with little capital
Assets Liabilities
10 Reserves Capital 4

90 Loans Deposits 96
Bank 1: stays
Assets Liabilities
10 Reserves Capital 5

85 Loans Deposits 90
Bank 2: insolvent
Assets Liabilities
10 Reserves Capital -1

85 Loans Deposits 96
Trade-off: bank 2 is a priori more profitable, but it
can easily become insolvent under loan defaults
Suppose that ROA is 1% in both banks
ROE = ROA * Assets / Capital

Bank 1:
ROE= 1% * 10 = 10%

Bank 2:
ROE= 1% * 25 = 25%
This is why regulation on capital
requirements is so important
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
 Credit/Default Management
Screening (ex-ante)
Monitoring (ex-post)
Long-term relationship with clients (trust)
Collateral
Credit rationing
General Banking Management
Liquidity
Assets
Liabilities
Capital requirements
Credit / Default Risk
Interest rates
Commercial Bank Balance Sheet
Assets Liabilities

20 Variable interest rate Variable interest rate 50

(loans, bonds, shares) (loans, accounts, deposits)

80 Fixed interest rate Fixed interest rate 50

(loans, bonds, reserves) (deposits, capital)
Effects of an increase of interest
rates of 5%
Assets increase by 1
Liabilities increase by 2.5
Banks profits fall by 1.5
. If interest rates fall, profits would increase

All due to the balance structure

How to manage interest rate risks

Swaps
Futures or options
 Swaps
Fixed interest rate
during 10 years

Bank 1 Bank 2
With a lot of fixed income assets
With a lot of variable income assets

Variable interest rate

during 10 years
- Yield curve also an issue here!
- Short-term funding, long-term investments
And now a little bit of regulation in
order to mitigate these bank risks
 Micro v/s Macro prudential
regulation

Micro-prudential regulation: stability at the individual

bank level

Macro-prudential regulation: stability at the system level

 So far, all we have seen is focused on
Micro-Prudential Banking Management
Micro-prudential Banking Regulation

Deposit insurance
Restrictions on assets
Banking supervision
Information transparency
Restrictions on minimal capital requirements
Liquidity buffers
 Deposit Insurance

Created in 1934 in EE.UU. (2000 banks collapsed by the Great

Depression of 1929)
Extended in Europe in the 1960s
Can cover all deposit or, for instance, 100.000
Problem: Moral hazard for banks
 Asset restrictions for banks

Risk taking
Asset Composition
Ring-fencing: Volcker rule / Vickers rule
Restrictions on Executives Bonuses
Competition
 Banking supervision

Supervisors supervise banks balance-sheets continuously

Supervisors can forbid some operations
Banks have to regularly provide info on regulation
Key issue right now, following the 2008 crisis
Stress Tests: How do banks respond to crisis-type scenarios
 Informational requirements

Informational transparency on
investments, balances
Comissions
 Capital restrictions

Capital Ratio: capital/assets > K %

Basel I (1988), 100 countries:
capital/ variable yield assets > 8%
Basel II (2007)
Ratio dependent on the risk of each asset
Risks can be measured with VAR-type measures
The more risks (market, credit, default), more required capital: Risk Weighted Assets
 Value at Risk (VAR)

Consists of estimating the maximum loss that a

bank can have on a given day: for instance, with
a 1% probability, it can lose 1 millions on that day
Banks try to minimize VAR given some interest
rates as well as liquidity / credit risks
 Capital restrictions

Basel III (2010-11): capital restrictions more strict, also focused on systemic
institutions

2008 crisis uncovers the systemic risk perils. The banking system is more
and more inter-connected. Even if most institutions are fine, the falling of
one could affect the system as a whole
 Different measurements

Systemic Risk: from VAR:

To CoVaR:
 Capital restrictions
New capital regulation more Macro-prudential
Additional capital requirements, higher capital buffers:
for unexpected losses (capital conservation)
counter-cyclical capital buffers: linked to excessive credit growth
capital buffers for systemic banks
additional and discretionary based on systemic risks
Example: capital structure, UK Banks

Source: Sir John Vickers, vox column, February 2016

 RWA: Risk Weighted Assets
Not all kinds of assets have the same risk
From the regulator/supervisor perspective, it is not the same for a bank to
holds cash v/s risky loan
How to compute RWA: e.g. all the cash or 0-risk asset (government debt)
gets subtracted from total assets, so that less capital requirements in capital
ratios (K/A) are needed if I have some of these assets
 Liquidity Buffers

Net-stable funding ratio (Basel III): reduce

dependence on short-term borrowing
More deposits
More long-term borrowing