Lecture 11: The Banking Firm & Bank Management

Introduction

Banks (depository institutions), the most important of all financial intermediaries, play a major
role in channeling funds to borrowers with productive opportunities. Banks are financial
institutions that accept money deposits and make loans. They are also important in ensuring the
financial system and economy run smoothly and efficiently. They play an important role in
determining the money supply and in transmitting the effects of monetary policy to the
economy, which is known as multiple deposit creation. They have been also a source of the
rapid financial innovation.

The Bank Balance Sheet

Balance sheet is a list of the assets and liabilities of a bank (or firm) that balances:

Total assets = Liabilities + Capital. Liabilities = source of bank funds

Assets = uses of bank funds

Balance Sheet (T-account)

Assets Liabilities
Reserves Checkable deposits
Cash items in process of collection Non-transaction deposits
Deposits at other banks Borrowings
Securities Bank Capital
Loans
Other Assets (e.g. physical capital)

Liabilities

1. Checkable deposits
 Checkable deposits include all accounts on which checks can be drawn.
 Checkable deposits are payable on demand; that is, if a depositor shows up at the bank and
requests payment by making a withdrawal, the bank must pay the depositor immediately.
 Checkable deposits are usually the lowest-cost source of bank funds as interest rates are low.

2. Non-transaction Deposits (primary source of funds)

 Saving deposits (common)
 Small-denomination time deposits & Large-denomination time deposits (fixed maturity length)((HigherCost)
 Owners cannot write checks on non-transaction deposits, but their interest rates are usually
higher than those on checkable deposits.

3. Borrowings
 Banks obtain funds by borrowing from the central bank, other banks, and corporations.

4. Bank Capital
 Bank Capitals (Bank’s Net Worth) = Total assets – Total Liabilities

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Assets

1. Reserves
 deposits + currency that is physically held by banks.
 Required reserves: Reserves that are held to meet the central bank requirement that for every
dollar of deposits at bank, a certain fraction must be kept as reserves.
 Required reserves ratio = required reserves/deposits
 Excess reserves: Reserves in excess of required reserves.

2. Cash Items in Process of Collection

 Deposits at Other Banks: Many small banks hold deposits in larger banks in exchange for a
variety of services including check collection, foreign exchange transactions, and help with
securities purchases.

3. Securities
 T-bills and longer-term government bonds. These kinds of bonds are called secondary reserves.

4. Loans
 Banks make their profits primarily by issuing loans.
 Including: (i) Commercial and industrial, (ii) Real estate, residential mortgage, (iii) Consumer,
(iv) Inter-bank

5. Other Assets
 The physical capital (bank building, computers, and other equipment) owned by the banks is
included in this category.
(1 and 2 are cash)ppp
Basic Operation of a Bank

Banks make profits by selling liabilities with one set of characteristics (a particular combination
of liquidity, risk, and return) and using the proceeds to buy assets with different set of
characteristics. This process is called asset transformation. (borrowing short and lending long).
For example, the bank has transformed the savings deposit (an asset held by the depositor) into a
loan (an asset held by the bank).

Using T-account (a simplified balance sheet) for analysis:

Case 1: Mr. A opens a checking account with cash deposit ($100) at the First National Bank
(FNB).
FNB
Assets Liabilities
Vault Cash +$100 Checkable deposits +$100

Assets Liabilities
Reserves +$100 Checkable deposits +$100

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Case 2: Mr. A opens the same account by issuing a check on an account at another bank
instead.
FNB
Assets Liabilities
Cash item in process +$100 Checkable deposits +$100
of collection

Assets Liabilities
Reserves +$100 Checkable deposits +$100

When a bank reserves additional deposits, it gains an equal amount of reserves.

Suppose the required reserves ratio = 10%, the FNB’s T-account is rewritten as follows:

FNB
Assets Liabilities
Required reserves +$10 Checkable deposits +$100
Excess reserves +$90

Reserves pay no interest, the bank is making loan instead of holding excess reserves.

FNB
Assets Liabilities
Required reserves +$10 Checkable deposits +$100
Loan +$90

The bank is making a profit because it holds short-term liabilities such as checkable deposits and
uses the proceeds to buy longer-term assets such as loans with higher interest rates.

General Principles of Bank Management

The bank management team has 4 primary concerns:

1. Liquidity Management
2. Asset Management
3. Liability Management
4. Managing Capital Adequacy

Liquidity Management

A bank’s liabilities include all the banks sources of funds. The amounts and sources of funds
clearly affect how much liquidity risk a bank has and how much liquidity it can create. The
easier a bank can access funds the less risk it has and the higher amount of funds it holds the
more liquidity it can create. The acquisition of sufficiently liquid assets is necessary to meet the
bank’s obligations to depositor (deposit outflows). For example, the bank has ample excess
reserves more than the required reserve ratio, says, 10%.

Initial balance sheet

FNB
Assets Liabilities
Reserves $20 Deposits $100
Loans $80 Bank capital $10
Securities $10

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Since required reserves = $10, then excess reserves = $10.
If a deposit outflow of $10 occurs, the bank’s balance sheet becomes:

Assets Liabilities
Reserves $10 Deposits $90
Loans $80 Bank capital $10
Securities $10

Now required reserves = $9 and excess reserves = $1.

If a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its
balance sheet. But banks do not like to hold excess reserves because excess reserves do not
generate any income!

Consider the following balance sheet:

Assets Liabilities
Reserves $10 Deposits $100
Loans $90 Bank capital $10
Securities $10

Now deposit outflow = $10, the bank has four options to meet this outflow with different costs.

1. Borrowings from other banks or corporation

Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Borrowings from other banks $9
Securities $10 Bank capital $10

Cost = interest rate on these loans.

2. Selling Securities

Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Bank capital $10
Securities $1

Cost = some brokerage and other transaction costs when the bank sells these securities.

3. Borrowing from the central bank

Assets Liabilities
Reserves $9 Deposits $90
Loans $90 Loans from the central bank $9
Securities $10 Bank capital $10

Explicit cost = interest rate on these loans.

Implicit cost = increased scrutiny of the bank by authority.

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4. Reduce lending

Assets Liabilities
Reserves $9 Deposits $90
Loans $81 Bank capital $10
Securities $10

Cost = losing customers relationship = losing customers = losing business

When a deposit outflow occurs, holding excess reserves allows the bank to escape the costs of
(1) borrowings from other banks or corporations, (2) selling securities, (3) borrowing from the
central bank, or (4) calling in or selling off loans. Excess reserves are insurance against the costs
associated with deposit outflows.

Asset Management

To maximize the bank’s profits, a bank must simultaneously (1) seek the highest returns possible
on loans and securities, (2) minimize risk, and (3) make adequate provisions for liquidity by
holding liquid assets. Banks try to accomplish these three goals in four basic ways:

1. Banks try to find borrowers who will pay high interest rates and are unlikely to default on
their loans.

2. Banks try to purchase securities (secondary reserves) with high returns and low risk.

3. In managing their assets, banks must try to minimize risk by diversifying.

For example, they purchase different types of bonds (T-bills vs. longer-term government
bonds), and approve many types of loans to a number of customers.

4. The bank must manage the liquidity of its assets so that it can satisfy its reserve
requirements without bearing huge costs. This means that it will hold liquid securities even
if they earn a somewhat lower return than other assets.

Managing Capital Adequacy

Banks make decisions about the amount of capital they need to hold for 3 reasons.

1. Regulatory authorities require a minimum amount of bank capital.

2. How Bank Capital helps prevent bank failure?

High Capital Bank

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

Bank capital = $10 / $100 = 0.1 = 10%

Assets

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 Low Capital Bank
Assets Liabilities
Reserves $10 Deposits $96
Loans $90 Bank Capital $4

Bank capital = $4 / $100 = 0.04 = 4%

Assets

If the real estate market collapses, banks may force to write off their bad loans ($5).

High Capital Bank

Assets Liabilities
Reserves $10 Deposits $90
Loans $85 Bank Capital $5

Low Capital Bank

Assets Liabilities
Reserves $10 Deposits $96
Loans $85 Bank Capital -$1

Low Capital Bank is insolvent now. When a bank becomes insolvent, government regulators
may close the bank. Therefore, a bank maintains bank capital to lessen the chance that it will
become insolvent.

3. How does the amount of Bank Capital affect Returns to Equity Holders?

Two measures of bank profitability:

i. Return on assets (ROA) = Net profit after taxes .

Assets
It measures how efficiently the bank is run.

ii. Return on equity (ROE) = Net profit after taxes

Equity (Bank) capital
It measures how well the owners are doing on their investment.

A direct relationship between ROA & ROE is called: Equity Multiplier (EM) = Assets
Equity Capital

Hence, we get the formula ROE = ROA x EM

High Capital Bank Low Capital Bank

Assets = $100 Bank Capital = $10 Assets = $100 Bank Capital = $4

EM = $100 = 10 EM = $100 = 25
$10 $4
If ROA1%, ROE10% If ROA1%, ROE25%

Given the ROA, the lower the bank capital, the higher the return for the owners of the bank.
Obviously, High Bank Capital => minimize the chance of insolvency, but also=> ROE is lower.

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Liability Management

Liabilities: checkable deposits, time deposits (e.g., CDs) and borrowings from other banks.

Starting in 1960s, the bank no longer needed to depend on checkable deposits as the primary
source of bank funds. Banks set target goals for their asset growth and tried to acquire funds (by
issuing liabilities) as they were needed.
When a large bank finds an attractive loan opportunity, it can acquire funds by selling a
negotiable CD.

Managing Credit Risk

In order to earn high profits, banks must make successful loans that are paid back in full. Banks
manage or minimize credit risk; they have to overcome the adverse selection and moral hazard.

Adverse selection in loan markets occurs because bad credit risks (those most likely to default
on their loans) are the ones who usually line up for loans. In other words, those who are most
likely to produce an adverse outcome are the most likely to be selected. Moral hazard exists in
loan markets because borrowers may have incentives to engage in activities that are undesirable
from the lender’s point of view. In such situations, it is more likely that the lender will be
subjected to hazard of default.

Screening and Monitoring

Screening: To undertake effective screening, banks collect reliable information from

prospective borrowers who are asked to provide information about their personal finances.
Effective screening and information collection form an important principle of credit risk
management.

Monitoring: To reduce moral hazard after making loan, banks must adhere to the principle for
managing credit risk that a bank should write provisions into loan contracts that restrict
borrowers from engaging in risky activities.

Specialization in Lending: A bank often specializes in lending to local firms or to firms in

particular industries, such as real estate. But she is not diversifying their portfolio of loans.

Long-term Customer Relationships

If a prospective borrower has had a checking or saving account or other loans with the bank over
a long period of time, the bank can lean from the past activities on the accounts and know more
about the potential borrower. It reduces the costs of information collection and make it easier to
screen out bad credit risks.

Loan Commitments
不是只睇⼀時波幅
A loan commitment is a bank’s commitment to provide a firm with loans up to a given amount at
an interest rate that is tied to some market interest rate. It promotes long-term relationship. The
firm continually supplies the bank with information about its income, asset and liability position.

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Collateral

The lender can sell collateral and use the proceeds to make up for its losses on the loan.

Compensating Balances

Compensating balances is a particular form of collateral is required when a bank makes

commercial loans is called compensating balances. It is especially common with corporate
loans. A firm receiving a loan must keep a required minimum amount of funds in a checking
account at the bank. It increases the cost of capital to the borrower reduce the lending cost for
the lender, since the lender can invest the cash placed in the compensating bank account.

Credit Rationing
Prevent moral hazards
Credit rationing takes two forms:
 A bank lender refuses to make a loan of any amount to a borrower, even though the borrower
is willing to pay the stated interest rate or even a higher rate.
 A bank is willing to make a loan but restricts the size of the loan to less than the borrower
would like.

Managing Interest-rate Risk

The riskiness of earnings and returns is associated with changes in interest rates.

FNB
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
e.g., variable-rate loans, short-term securities e.g., variable-rate CDs

Fixed-rate assets $80M Fixed-rate liabilities $50M

e.g., reserves, long-term loans, long-term securities e.g., checkable deposits, saving deposits

With no transaction costs, suppose that interest rates rise by 5 percentage points, say, on average
from 10% to 15%.

Income on the assets : 5%×20M = 1M

Payments on the liabilities : 5%×50M = 2.5M
Bank’s profit : 2.5M – 1M = 1.5M

Similarly, if interest rates decrease from 10% to 5%, bank’s profits  1.5M.

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.

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Basic (Income) Gap Analysis

The sensitivity of bank income or profits to changes in interest rates can be measured more
directly using gap analysis (also called income gap analysis).

GAP = Interest Rate Sensitive Assets (ISA) – Interest Rate Sensitive Liabilities (ISL)
= 20M – 50M = – 30M

If it is positive, it is called positive gap or asset-sensitive gap.

If it is negative, it is called negative gap or liability-sensitive gap.

Profits = i x GAP

For the negative gap: 10% increases to 15%, Bank’s profits = 5%×(-30M) = -1.5M
10% decreases to 5%, Bank’s profit = -5%×(-30M) = 1.5M

Gap management is a technique for protecting a financial institution’s earnings from losses due
to changes in interest rates by matching the volume of ISA held to the volume of ISL taken on.
The bank management team believes that interest rates will fall in the future, they will change
the portfolio; they may reduce rate-sensitive assets, and increase rate-sensitive liabilities.

A negative gap may be a reflection of a bank’s belief that interest rates will fall.
A positive gap may be a reflection of a bank’s belief that interest rates will rise.

Interest-rate Swaps
Between banks
FNB can swap with SNB to get rid of interest risk for both parties. There is an agreement (OTC
traded) between two parties where one stream of future interest payments is exchanged for
another based on a specified principal amount. An interest-rate swap is a derivative in which
one party exchanges a stream of interest payments for another party's stream of cash flows.
Interest-rate swaps enable a financial institution that has more rate-sensitive assets than rate-
sensitive liabilities to ‘swap’ payment streams with a financial institution that has more rate-
sensitive liabilities than rate-sensitive assets, thereby reducing interest-rate risk for both. They
are very popular instruments and can be used by hedgers to manage their fixed or floating assets
and liabilities.

For example, FNB would like to convert $30M of its fixed-rate assets into $30M of rate-
sensitive assets.
FNB
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
(+$30M)
Fixed-rate assets $80M Fixed-rate liabilities $50M
(–$30M)

SNB
Assets Liabilities
Rate-sensitive assets $80M Rate-sensitive liabilities $50M
(–$30M)
Fixed-rate assets $20M Fixed-rate liabilities $50M
(+$30M)

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Off-Balance-Sheet Activities

Fee Income

There are many types of income generated specialized services:

 Foreign exchange trades for customers
 Servicing mortgage-backed securities
 Loan Commitment / Guarantees of debt
 Backup lines of credit

It involves trading financial instruments and generating income from fees and loan sales,
activities that affect bank profits but do not appear on bank balance sheets, at least, temporarily.

Trading Activities

Financial derivatives such as financial forwards and futures, options, swaps, can help the bank
reduce its interest-rate risk. Banks engaged in international banking also trade in foreign
exchange market. These activities also help bank make profits.

Securitisation and Loan sales (secondary loan participation)

 Securitisation turns illiquid loans or financial assets into liquid assets which are usually
marketable capital market securities. The bank can earn added fee income by the related
services.
 Under a loan participation agreement, a bank will sell all or part of the cash stream from a
specific loan and thereby removes the loan from the bank balance sheet.
 Collateralized debt obligations (CDOs) [債務抵押債券] are a type of asset-backed security
and structured credit product such as CLO (Collateralised Loan Obligation) and CBO
(Collateralised Bond Obligation). CDOs gain exposure to the credit of a portfolio of fixed-
income assets and divide the credit risk among different tranches.
 A structured investment vehicle (SIV) is a fixed income maturity transformation fund,
similar to a CDO. An SIV is an entity set up when a bank buys long-term assets that have
less liquidity but pay higher yields and finances them by issuing short-term commercial
paper (CP) that is continuously renewed or rolled over. The SIVs often employ great
amounts of leverage to generate returns. They are a type of structured credit product; they
are usually investing in a range of asset-backed securities, as well as some financial
corporate bonds. Unlike a CDO, an SIV has an open-ended (or evergreen) structure; it plans
to stay in business indefinitely by buying new assets as the old ones mature.
 It increases risk as the leverage increases.

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