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FINA 3040B
CENTRAL BANKING AND
REGULATION OF FINANCIAL
INSTITUTIONS
BANKING & THE MANAGEMENT OF
FINANCIAL INSTITUTIONS

Dr. Paul M. Kitney

Term 2, 2020-21
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The Bank Balance Sheet

• Liabilities:
• Checkable deposits
• Non-transaction deposits
• Borrowings
• Bank capital
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The Bank Balance Sheet

• Assets:
• Reserves
• Cash items in process of collection
• Deposits at other banks
• Securities
• Loans
• Other assets
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Balance Sheet of All Commercial Banks (Items as a

Percentage of the Total, June 2017
Assets (Uses of Funds)* Blank Liabilities (Sources of Funds) Blank

Reserves and cash items 14% Checkable deposits 11%

Securities Blank Non-transaction deposits Blank

U.S. government and agency 15 Savings deposits 49

State and local government and other 6 Small denomination time deposits 2
securities
Blank Blank Large-denomination time deposits 10
Blank Blank Borrowings 17
Blank Blank Bank capital 11
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Balance Sheet of All Commercial Banks (Items as a

Percentage of the Total, June 2017
Assets (Uses of Funds)* Blank Liabilities (Sources of Funds) Blank

Loans Blank Blank Blank

Commercial and industrial 13 Blank Blank

Real estate 26 Blank Blank

Consumer 8 Blank Blank

Interbank 1 Blank Blank

Other 9 Blank Blank

Other assets (for example, physical capital) 8 Blank Blank

Total 100 Total 100

Source: Federal Reserve Bank of St. Louis, FRED database: http://www.federalreserve.gov/releases/h8/current/ and
https://www.federalreserve.gov/releases/H6/current.
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Basic Banking
• Cash Deposit:

First Blank Blank Blank First Blank Blank Blank

National National
Bank Bank
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Vault cash +$100 Checkable +$100 Reserves +$100 Checkable +$100
deposits deposits

• 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 Blank Blank Blank When a bank receives additional
Assets Blank Liabilities Blank deposits, it gains an equal amount
Cash items in process +$100 Checkable +$100 of reserves; when it loses deposits,
of collection deposits it loses an equal amount of
reserves. Eg. Check drawn against
Second National deposited in First
National
First National Bank Blank Blank Blank Second National Blank Blank Blank
Bank
Assets Blank Liabilities Blank
Assets Blank Liabilities Blank
Reserves +$100 Checkable +$100
deposits Reserves −$100 Checkable −$100
deposits
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Basic Banking
First National Blank Blank Blank First National Blank Blank Blank
Bank Bank
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Required reserves +$10 Checkable +$100 Required reserves +$10 Checkable +$100
deposits deposits
Excess reserves +$90 Blank Blank Loans +$90 Blank Blank

• 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
• Question? What influence does the yield curve have on bank profitability?
• Question? If a bank earns 10% on loans, pays 5% on deposits, it costs $3 per year
to cover bank overhead costs to service the account, what is the bank profit?
• Answer. Bank earns 10% on $90 = $9. Bank pays out 5% on deposits or 5% of 100
= $5. Banks costs are $3. So the bank’s profit on the loan is $9-$5-$3 = $1 plus any
interest earned on the required reserves
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General Principles of Bank

Management

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
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Liquidity Management and the Role

of Reserves
• Excess reserves:
Case A Case B
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank Capital $10M Loans $80M Bank Capital $10M
Securities $10M Blank Blank Securities $10M Blank Blank

• Assets – Liabilities = Bank Capital

• Suppose a bank’s required reserves are 10% (that is 10% of the deposit
amount)
• In Case A how much are excess reserves?
• In Case B, $10 million of deposits are withdrawn from the bank. How much
are excess reserves now? Has liquidity improved or not?
• 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 the Role

of Reserves
• Shortfall:

Assets Blank Liabilities Blank Assets Blank Liabilities Blank

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $10M
Securities $10M Blank Blank Securities $10M Blank Blank

• Reserves are a legal requirement and the shortfall must be eliminated.

• Excess reserves are insurance against the costs associated with deposit
outflows.
• Borrow from other banks in the interbank market or Federal Funds Market
or issues CD’s to corporations, essentially borrowing from corporations
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Liquidity Management and the Role

of Reserves
• Borrowing:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

• Cost incurred is the interest rate paid on the borrowed funds

• Borrowing costs from other banks or corporations will be higher than
sourcing funds from deposits
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Liquidity Management and the Role

of Reserves
• Securities sale:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M Blank Blank

• Selling securities will add to reserves to cover a shortfall to meet reserve

requirement of 10%
• The cost of selling securities is the brokerage and other transaction costs.
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Liquidity Management and the Role

of Reserves
• Federal Reserve:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank capital $10M

• The bank borrows from the Fed at the discount rate, raising reserves to
meet the reserve requirement
• Borrowing from the Fed also incurs interest payments based on the discount
rate.
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Liquidity Management and the Role

of Reserves
• Reduce loans:
Assets Blank Liabilities Blank
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M Blank Blank

• Reduction of loans is the most costly way of

acquiring reserves.
• Calling in loans ($9 million) antagonizes customers.
• Other banks may only agree to purchase loans at a substantial discount.
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Asset Management

Three goals:

1. Seek the highest possible returns on loans and securities.

2. Reduce risk.

3. Have adequate liquidity.

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Asset Management
Four Tools:

1. Find borrowers who will pay high

interest rates and have low possibility
of defaulting.

2. Purchase securities with high returns and low risk.

3. Lower risk by diversifying.

4. Balance need for liquidity against increased returns from less liquid
assets.
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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
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Capital Adequacy Management

How Bank Capital Helps Prevent Bank Failure (Example $5 million loan write off)

High Capital Blank Blank Blank Low Capital Blank Blank Blank
Bank Bank
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million
Loans $90 million Bank capital $10 million Loans $90 million Bank capital $ 4 million

High Capital Blank Blank Blank Low Capital Blank Blank Blank
Bank Bank
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million
Loans $85 million Bank capital $ 5 million Loans $85 million Bank capital −$ 1 million
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Capital Adequacy Management

How the Amount of Bank Capital Affects 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
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
ROE = ROA  EM
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Capital Adequacy Management

• Trade-off between safety and returns to equity holders:
• 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
• Bank capital requirements are an important bank of bank regulation,
which help balance the trade-off (see next week)
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Application: How a Capital Crunch Caused a Credit

Crunch During the Global Financial Crisis

• 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
tighten their lending standards and reduce lending.
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Managing Credit Risk

• Screening and Monitoring:

• Screening
• Specialization in lending
• Monitoring and enforcement of
restrictive covenants
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Managing Credit Risk

• Long-term customer relationships

• Loan commitments
• Collateral and compensating balances
• Credit rationing
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Managing Interest-Rate Risk

Blank First National Bank Blank Blank

Assets Blank Liabilities Blank

Rate-sensitive assets $20 million Rate-sensitive liabilities $50 million
Variable-rate and Blank Variable-rate CDs Blank
short-term loans
Short-term securities Blank Money market deposit Blank
accounts
Fixed-rate assets $80 million Fixed-rate liabilities $50 million
Reserves Blank Checkable deposits Blank

Long-term loans Blank Savings deposits Blank

Long-term securities Blank Long-term CDs Blank

Blank Blank Equity capital Blank

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Gap Analysis
• Basic gap analysis:
(rate sensitive assets – rate sensitive liabilities) × Δ interest rates = Δ in
bank profit
• Question? If interest rates on average increase from 10% to 15% in our
example, what is the change in profit for First National Bank?
• Maturity bucked approach:
• Measures the gap for several maturity subintervals
• Standardized gap analysis:
• Accounts for different degrees of rate sensitivity
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Duration and Interest Rate Risk

• A bond with a longer term to maturity has a larger change in its price or
higher “interest rate risk” in response to a change in interest rates, than a
bond with a shorter term to maturity – Demonstrated in Lecture 3.
• To measure interest rate risk, a manager at a financial institution needs a
more precise measure about the capital gain or loss arising from changes
in interest rates, to its debt securities portfolio.
• This measure involves the concept of “Duration” – the average lifetime of
a debt security’s stream of payments
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Duration and Interest Rate Risk

• Two bonds with the same term to maturity does not mean they have the
same duration or interest rate risk
• Compare a coupon paying and zero-coupon bond with 10 years to
maturity.
• A zero coupon discount bond makes all its “payments” at the end of 10
years, while a coupon bond pays along the way, before maturity.
• In can be said that the zero coupon discount bond’s “effective maturity” –
the term to maturity that measures interest rate risk – is shorter than the
zero coupon discount bond.
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Duration and Interest Rate Risk

• Following the example in Lecture 3, we consider a 10-year, zero-coupon
bond with a face value of $1000, where the interest rate increases from
10% to 20%.

• The price of the bond one year from now, 𝑃𝑡+1 =

𝐹
(1+𝑖)𝑛−1
=
1000
(1+0.2)9
=
𝐹 1000
$193.81 and price of the bond today, 𝑃𝑡 = = = $385.54.
(1+𝑖)𝑛 (1+0.1)10

• The capital gain is 𝑔 =

𝑃𝑡+1 −𝑃𝑡
𝑃𝑡
=
193.81−385.54
385.54
= −49.7%

• In Lecture 3, we showed that the capital gain of a 10% 10-year coupon

bond was -40.3%
• The interest rate risk is less for the coupon bond than zero-coupon bond
• Hence, the effective maturity on the coupon bond is as expected shorter
than that of the zero-coupon bond
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Calculating Duration

• We calculate duration using a method devised by NBER researcher,

Frederick Macaulay.

• First, Macauley set the effective maturity of a zero coupon bond equal to
its actual maturity.

• Macauley concluded that he could measure the effective maturity of a

coupon bond since a coupon bond could be represented by a series of
zero-coupon, discount bonds.
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Calculating Duration
• A 10-year 10% coupon bond with a face value of $1000 has cash
payments equivalent to the payoffs of the following set of zero coupon
bonds: a $100 one-year zero-coupon bond (which pays the equivalent of
the $100 coupon payment made by the $1,000 ten-year 10% coupon
bond at the end of one year), a $100 two-year zero-coupon bond (which
pays the equivalent of the $100 coupon payment at the end of two years),
…, a $100 ten-year zero-coupon bond (which pays the equivalent of the
$100 coupon payment at the end of ten years), and a $1,000 ten-year
zero-coupon bond (which pays back the equivalent of the coupon bond’s
$1,000 face value).
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Calculating Duration

• To obtain the effective maturity we sum the effective maturities of all ZC

bonds, weighting each by the percentage of total value of all.
• First, in column (3) the PV of each zero coupon bond is calculated.
• Second, Divide each PV by $1000 to obtain the percentage of total value
each bond represents
• Finally add the weighted maturities in (5) to obtain duration of 6.76
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Calculating Duration
• The sum of the weighted maturities of each zero-coupon bond (maturity
= effective maturity for ZCB) is the effective maturity of the set of ZC
bonds is equivalent to the duration of the 10% 10-year coupon bond.
• Duration calculation in the previous table can be summarized by the
following formula:
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Duration Facts
• Ceteris paribus, the longer the term to maturity of a bond the longer
its duration – If we compute duration for a 11-year 10% coupon bond
(interest rate is 10%), duration is 7.14 years > 6.76 year (10-yr bond)
• Ceteris paribus, when interest rates rise, the duration of the coupon
bond falls – If we redo our computation for the 10-year, 10% coupon
bond but raise the interest rate to 20%, the duration falls to 5.72 years.
• Ceteris paribus, the higher the coupon rate on a bond the shorter the
bond’s duration – If we redo our computation using a 10-year, 20%
coupon bond with 10% interest rates, the duration falls to 5.98 years.
• Duration additivity – The duration of a portfolio of securities is the
weighted average of the duration of the individual securities. For
example, if PIMCO or ICBC portfolio has 25% in bonds with 5-year
duration and 75% with 10-year duration, then the portfolio duration is
(0.25 x 5) + (0.75 x 10) = 1.25 + 7.5 = 8.75 years.
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Duration & Interest Rate Risk

• What would be the impact on the portfolio of a pension fund, it this fund
has a holding of a 10-year 10% coupon bond and interest rate rises from
10% to 11%.
• The estimated change in the price of the bond, due to a change in
interest rates, is given by the following:

• We know DUR = 6.76, Δi = 0.11-0.11 = 0.01 and i = 0.1

• So %ΔP ≈ -6.76 x
0.01
1+0.1
= −6.15%
• Note that the greater the duration of the bond or portfolio, the greater
the interest rate risk
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Duration Gap and Net Worth

• We apply the concept of duration to financial institutions balance sheets
top determine interest rate sensitivity to net worth, based on their
asset/liability mix. The duration gap is given by the following:

• Suppose average duration of assets is 2.7 and average duration of

liabilities is 1.03, the market value of assets and liabilities are $95 million
and $100 million, respectively ( see table on the next slide)
• Duration Gap = 2.7 – (0.95 x 1.03) = 1.72 years
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Duration Gap and Net Worth

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Duration Gap and Net Worth

• A bank manager using the duration gap analysis conducted here to
estimate the change in the market value of net worth as a percentage of
total assets, given by the following equation:
• What is the change in the market value of net worth in our bank example,
as a percentage of total assets if interest rates rise from 10% to 11%?

• ∆𝑁𝑊
𝐴
= −1.72
0.01
1+0.1
= −0.016
• Change in net worth (as a percentage of total assets) is -1.6%, as assets
are $100 million, the increase in interest rates from 10 to 11 percent,
reduces the market value of net worth by 0.016 x $100 million = $1.6 mil.
• This bank will suffer from a rise in interest rates so that net worth will fall
by a third of total bank capital, $5 million. Bank management will realize
the asset/liability mix subjects this bank to significant interest rate risk as
a rise in interest rates can reduce bank capital substantially
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Management

• What risk management measures could a bank manager take to lower

interest rate sensitivity?

• Shorten the duration of the firm’s assets – by purchasing assets of shorter

maturity or perhaps converting fixed rate loans to adjustable rate loans

• Lengthen the duration of liabilities

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Principal Agent Problem

• Principal Agent Problem – When one person or entity is able to make
decisions or take actions on behalf of a principal. Agents are motivated to
act in their own self interest, contrary to the principal. This is an example
of moral hazard. More on this next lecture.
• Internal controls to reduce the principal-agent problem:
• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk
• Stress testing
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Rogue Traders and the Principal–

Agent Problem

• The demise of Barings, a venerable British bank more than a century old,
is a sad morality tale of how the principal–agent problem operating
through a rogue trader (agent) can take a financial institution (principal)
that has a healthy balance sheet one month and turn it into an insolvent
tragedy the next.