Banking and the Management of Financial Institution

The bank borrows short and lends long -> how banks generate
profits
General Principles of Bank Management
Liquidity Management and the Role of Reserves
The management of liquid assets to meet banks
obligations to depositors
The banks need % of total deposits as reserves for the
withdrawal of such
Shortage:
Borrowing: the cost is the interest rate
Sell securities: the cost is the transaction costs
Borrow from Fed (discount loans): the cost is the
interest rate (discount rate)
Asset Management
- The bank must pursue an acceptably low level of risk by
acquiring assets that have low rate of default and by
diversifying asset holdings
1) Find borrowers who will pay high interest rates
2) Purchase securities with high returns and low risk
3) Lower risk (of 2) by diversifying
4) Balance need for liquidity (hold liquid assets even
though they have low returns)
Liability Management
- Acquire funds in low cost
Capital Adequacy Management
Bank Failure:: Bank A: 10M Capital; Bank B: 4M Capital
o If the bank realizes that 5 million of the loans
lent out will not be recoverable, Bank A will still have

5M in the capital while Bank B will have a problem since

it has -1M
o apital
Affects Returns to Equity Holders
Managing Interest-Rate Risk
If a bank has more rate-sensitive liabilities than assets:
o Increase in interest rates -> will reduce bank
profits
o Decrease in interest rates -> will increase
bank profits
Gap and Duration Analysis
Off-Balance Sheet Activities
Involve trading financial instruments and generating
income from fees and loan sales, activities that affect bank
profits but do not appear on the balance sheet
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