Bank Management Snap Shot

Chapter Objectives
Explain what a balance sheet and a Taccount are. Explain what banks do in five words and also at length. Describe how bankers manage their banks balance sheets. Explain why regulators mandate minimum reserve and capital ratios. Describe how bankers manage credit risk. Describe how bankers manage interest-rate risk. Describe off-balance sheet activities and explain their importance.

1. The Balance Sheet

Chapter Objectives Explain what a balance sheet and a T-account are.

What is a balance sheet and what are the major types of bank assets and liabilities?

1. The Balance Sheet

ASSETS = LIABILITIES + EQUITY

Uses of Funds = Sources of Funds

Assets =
Resources = Resources =

Debt Financing + Equity Financing

Borrowings + Ownership stakes Lenders claims + Owners claims

1. The Balance Sheet For banks

ASSETS = LIABILITIES + EQUITY

Assets: Reserves Secondary reserves Loans made to customers Other Liabilities: Deposits owed to customers Borrowings owed to debt financers

Equity: Shareholders equity

1. The Balance Sheet

Key Takeaways
A balance sheet is a financial statement that lists what a company owns, its assets or uses of funds, and what it owes, its liabilities or sources of funds. Major bank assets include reserves, secondary reserves, loans, and other assets. Major bank liabilities include deposits, borrowings, and shareholder equity.

2. Assets, Liabilities.
Chapter Objectives Explain what banks do in five words and also at length.

In five words, what do banks do? Without a word limitation, how would you describe what functions they fulfill?

2. Assets, Liabilities.

For banks
ASSETS Reserves: cash and deposits at the Fed
Required reserves + excess reserves = total reserves

Secondary reserves: Government and liquid

securities

Loans: commercial, consumer, to other banks via

Fed Funds or check clearing

Collateralized: mortgage, auto, call loan, etc. Other property, equipment, etc.

2. Assets, Liabilities. For banks

LIABILITIES Liabilities:
Deposits Transaction deposits: checking, Non-transaction deposits: savings, Short term, Fixed etc Time deposits: CDs Borrowings from banks via Fed Funds, from Federal Reserve via discount window

2. Assets, Liabilities. For banks

EQUITY Equity:
Shareholders equity Common stock Preferred stock Retained earnings

2. Assets, Liabilities. For banks

ASSETS =
Assets: Reserves: cash and deposits at the Fed Required reserves + excess reserves = total reserves Secondary reserves Government and liquid securities Loans: commercial, consumer, to other banks via Fed Funds or check clearing Collateralized: mortgage, auto, call loan Other property, equipment, etc

LIABILITIES + EQUITY
Liabilities: Deposits Transaction deposits: checking, Non-transaction deposits: savings, Time deposits: CDs Borrowings from banks via Fed Funds, from Federal Reserve via discount window Equity: Shareholders equity Common stock Preferred stock Retained earnings

2. Assets, Liabilities.

Asset transformation: Banks

Intermediaries

Short-term deposits/ Longterm deposits

Borrow short Lend long

Long-term loans

Investors

Entrepreneurs

2. Assets, Liabilities.

Asset transformation: Finance Companies

Intermediaries

Buy bonds or finance

Savers/Investors

Borrow long Lend short

Short-term loans
Spenders/Entrepreneurs

2. Assets, Liabilities.

Asset transformation: Insurance

Intermediaries

Prepay expense
Savers/Investors

Contingent liabilities
Spenders/Entrepreneurs

2. Assets, Liabilities.
Key takeaways
Banks: lend (1) long (2) and (3) borrow (4) short (5). Like other financial intermediaries, banks are in the business of transforming assets, of issuing liabilities with one set of characteristics to investors and of buying the liabilities of borrowers with another set of characteristics. Generally, banks issue short-term liabilities but buy long-term assets. This raises specific types of management problems bankers must be proficient at solving if they are to succeed.

3. Bank Management Principles

Chapter Objectives
Describe how bankers manage their banks balance sheets. Explain why regulators mandate minimum reserve and capital ratios.

What are the major problems facing bank managers and why is bank management closely regulated?

3. Bank Management Principles

Bankers must manage their assets and liabilities to ensure

Liquidity Profit Profit Financing

Liquidity management Asset management Liability management Capital adequacy management

3. Bank Management Principles Liquidity management

Have enough reserved to satisfy deposit outflows

Use efficiently enough to earn profit

3. Bank Management Principles Asset and Liability management

Financing

Investments

Profit

3. Bank Management Principles Capital adequacy management

Have enough to protect against bankruptcy or regulation

Use efficiently enough to earn profit

3. Bank Management Principles Bank management risks

Default

Liquidity

Profit
Interest rate

Capital adequacy

3. Bank Management Principles Liquidity management

Net deposit outflow (inflow) Reserve ratio decreases (increase) Increase (decrease) reserves
in the cheapest way possible
Sell (buy) assets high transaction costs Sell (extend) loans adverse selection Sell (buy) securities Call in (extend) loans high opportunity costs Increase (decrease) deposits high transaction costs and added operating costs Borrow from discount window (Fed) Borrow from (lend to) Fed Funds (other banks)

3. Bank Management Principles Asset management

Risk vs. Return: Default rate vs. Interest earned

Diversification: sectors, industries, markets, regions Reserve decision: invest vs. reserve

3. Bank Management Principles Liability management

Actively try to attract deposits

Sell large denomination (Saving Deposits) to institutional investors Borrow from other banks in the overnight federal funds market

3. Bank Management Principles Capital adequacy management

Net worth vs. profit
ROA: net after-tax profit/assets ROE: net after-tax profit/equity (capital, net worth) Increased leverage (debt financing) increases assets (A = L + E) Increased leverage (risk) increases ROE (return)

Regulators in many countries have therefore found it prudent to mandate capital adequacy standards to ensure that some bankers are not taking on high levels of risk in the pursuit of high profits.

3. Bank Management Principles Capital adequacy management

Capital management to increase ROE:
Buy (sell) the banks stock in the open market, reducing (increasing) the number of shares outstanding, raising (decreasing) capital and ROE. Pay (withhold) dividends, decreasing (increasing) capital and ROE. Increase (decrease) the banks assets (with capital and ROA held constant), increasing (decreasing) ROE.

3. Bank Management Principles

They must feel the thrill of totting up a balanced book A thousand ciphers neatly in a row. When gazing at a graph that shows the profits up Their little cup of joy should overflow!
- Robert B. and Richard M. Sherman, from A British Bank from Mary Poppins (1964)

3. Bank Management Principles

Key Takeaways
Bankers must manage their banks liquidity (reserves regulatory and to conduct business effectively), capital (adequacy regulatory and to buffer against negative shocks), assets, and liabilities. There is an opportunity cost to holding reserves, which pay no interest, and capital, which must share the profits of the business. While bankers left to their own judgments would hold reserves > 0 and capital > 0, they might not hold enough to prevent bank failures at what the government or a countrys citizens deem an acceptably low rate. That induces government regulators to create and monitor minimum requirements.

4. Credit Risk

Chapter Objectives Describe how bankers manage credit risk.

What is credit risk and how do bankers manage it?

4. Credit Risk Managing asymmetric information A banker is a fellow who lends his umbrella when the sun is shining and wants it back the minute it begins to rain. - Mark Twain (1835-1910)

4. Credit Risk
No matter how good bankers are at asset, liability, and capital adequacy management, they will be failures if they cannot manage credit risk Managing credit risk managing Asymmetric information
Adverse selection Moral hazard

4. Credit Risk Managing asymmetric information

Screening
reduce adverse selection

create information/reduce asymmetry embed information in binding contract third-party verification maximize efficiency of screening create exposure to systemic risk loan commitments (line of credit) other business services

Specialization
Increase efficiency

Long-term
reduce moral hazard

4. Credit Risk Managing asymmetric information

Securitize
reduce moral hazard

collateral compensatory balances loan covenants no credit at any interest rate limit credit

Credit rationing
reduce adverse selection reduce moral hazard

4. Credit Risk
Key Takeaways
Credit risk is the chance that a borrower will default on a loan by not fully meeting stipulated payments on time. Bankers manage credit risk by screening applicants (taking applications and verifying the information they contain), monitoring loan recipients, requiring collateral like real estate and compensatory balances, and including a variety of restrictive covenants in loans. They also manage credit risk by trading off between the costs and benefits of specialization and portfolio diversification.

5. Interest-Rate Risk

Chapter Objectives
Describe how bankers manage interest-rate risk.

What is interest rate risk and how do bankers manage it?

5. Interest-Rate Risk
Financial intermediaries are exposed to interest rate risk because their assets and liabilities are exposed to interest rate risk. Interest rate risk is determined by the value of risk-sensitive assets, the value of risk-sensitive liabilities, and the change in interest rates.

5. Interest-Rate Risk
Basic Gap Analysis CP = (Ar Lr) x i CP: changes in profitability Ar: risk-sensitive assets Lr: risk-sensitive liabilities i: change in interest rates

5. Interest-Rate Risk

Interest rates rise:

Asset values increase

Interest rates fall:

Asset values decrease

Interest rates rise:

Liability values decrease

Interest rates fall:

Liability values increase

5. Interest-Rate Risk

If A > L and interest rates rise,

Profitability rises

If A < L and interest rates rise,

Profitability falls

If A > L and interest rates fall,

Profitability falls

If A < L and interest rates fall,

Profitability rises

5. Interest-Rate Risk
To account for differences in maturities of assets and liabilities, duration is used to estimate sensitivity to interest rate changes: %P = -%i x d %P: percentage change in market value %i: change in interest (NOT decimalized, i.e., represent 5% as 5 not .05. Also note the negative sign. The sign is negative because, as we learned interest rates and prices are inversely related.) d: duration (years).

5. Interest-Rate Risk
Strategy Implications
Interest rates are expected to fall: duration of liabilities short (borrow short) and duration of assets long (lend long). Interest rates are expected to rise: duration of liabilities long (borrow long) and duration of assets short (lend short).

5. Interest-Rate Risk
Key Takeaways
Interest rate risk is the chance that interest rates may increase, decreasing the value of bank assets. Bankers manage interest-rate risk by performing analyses like basic gap analysis, which compares a banks interest rate-risk sensitive assets and liabilities, and duration analysis, which accounts for the fact that bank assets and liabilities have different maturities. Such analyses combined with interest rate predictions tell bankers when to increase or decrease their rate-sensitive assets or liabilities and whether to shorten or lengthen the duration of their assets or liabilities. Bankers can also hedge against interest-rate risk by trading derivatives, like swaps and futures, and engaging in other off-balance sheet activities.

6. Off the Balance Sheet

Chapter Objectives
Describe off-balance sheet activities and explain their importance.

What are off balance sheet activities and why do bankers engage in them?

6. Off the Balance Sheet

Hedge credit risk Diversify revenue service fees loan origination fees sell loans (provide loan guarantees)

6. Off the Balance Sheet The 2008 Crisis: Credit default swaps
Credit default swaps, which were invented by Wall Street in the
late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default -- that is, when the stream of revenue behind the loan becomes insufficient to meet the payments that were promised. Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss.
The New York Times, as quoted in Times Topics

6. Off the Balance Sheet The 2008 Crisis: Credit default swaps
The market for the credit default swaps has been enormous. Since
2000, it has ballooned from $900 billion to more than $45.5 trillion roughly twice the size of the entire United States stock market. Also in sharp contrast to traditional insurance, the swaps are totally unregulated. The swaps' complexity and the lack of information in an unregulated market added to the market's anxiety. Bond insurers like MBNA and Ambac that had written large amounts of the swaps saw their shares plunge in late 2007..
Michael Lewitt, September 16, 2008, The New York Times, as quoted in Times Topics

6. Off the Balance Sheet The 2008 Crisis: Credit default swaps
Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter. Alan Greenspan, Chairman, U.S. Federal Reserve 1987-2006 In The Economist, December 18, 2008

6. Off the Balance Sheet

Hedge interest rate risk Derivatives trading Interest rate swaps Currency trading Trading on account

6. Off the Balance Sheet

Key takeaways
Off-balance sheet activities like fees, loan sales, and derivatives trading help banks to manage their interest-rate risk by providing them with income that is not based on assets (and hence is off the balance sheet). Derivatives trading can be used to hedge or reduce interest-rate risks but can also be used by risky bankers or rogue traders to increase risk to the point of endangering a banks capital cushion and hence its economic existence.

Bank Management - Snapshot

Chapter Summary
A balance sheet is a financial statement that lists what a company owns, its assets or uses of funds, and what it owes, its liabilities or sources of funds. Major bank assets include reserves, secondary reserves, loans, and other assets. Major bank liabilities include deposits, borrowings, and shareholder equity. Banks: lend (1) long (2) and (3) borrow (4) short (5). Like other financial intermediaries, banks are in the business of transforming assets, of issuing liabilities with one set of characteristics to investors and of buying the liabilities of borrowers with another set of characteristics.

Chapter 9 Bank Management

Chapter Summary
Generally, banks issue short-term liabilities but buy long-term assets. This raises specific types of management problems bankers must be proficient at solving if they are to succeed. Bankers must manage their banks liquidity (reserves regulatory and to conduct business effectively), capital (adequacy regulatory and to buffer against negative shocks), assets, and liabilities. There is an opportunity cost to holding reserves, which pay no interest, and capital, which must share the profits of the business.

Chapter 9 Bank Management

Chapter Summary
While bankers left to their own judgments would hold reserves > 0 and capital > 0, they might not hold enough to prevent bank failures at what the government or a countrys citizens deem an acceptably low rate. That induces government regulators to create and monitor minimum requirements. Credit risk is the chance that a borrower will default on a loan by not fully meeting stipulated payments on time. Bankers manage credit risk by screening applicants (taking applications and verifying the information they contain), monitoring loan recipients, requiring collateral like real estate and compensatory balances, and including a variety of restrictive covenants in loans.

Chapter 9 Bank Management

Chapter Summary
They also manage credit risk by trading off between the costs and benefits of specialization and portfolio diversification. Interest rate risk is the chance that interest rates may increase, decreasing the value of bank assets. Bankers manage interest-rate risk by performing analyses like basic gap analysis, which compares a banks interest rate-risk sensitive assets and liabilities, and duration analysis, which accounts for the fact that bank assets and liabilities have different maturities. Such analyses combined with interest rate predictions tell bankers when to increase or decrease their rate-sensitive assets or liabilities and whether to shorten or lengthen the duration of their assets or liabilities.

Chapter 9 Bank Management

Chapter Summary
Bankers can also hedge against interestrate risk by trading derivatives, like swaps and futures, and engaging in other offbalance sheet activities. Off-balance sheet activities like fees, loan sales, and derivatives trading help banks to manage their interest-rate risk by providing them with income that is not based on assets (and hence is off the balance sheet). Derivatives trading can be used to hedge or reduce interest-rate risks but can also be used by risky bankers or rogue traders to increase risk to the point of endangering a banks capital cushion and hence its economic existence.