Cfa 2

Faculdade de Economia da Universidade do Porto
Master in Finance
Financial Institutions
[2]
Carlos Francisco Alves

2023-2024
Banking and the Management of

[Commercial Banks]
Financial Institutions - Master in Finance - C. Alves - 2023-2024 2
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“First of all let me state the simple

fact that when you deposit money in
a bank, the bank does not put the
money into a safe deposit vault. It
invests your money in many
different forms of credit – bonds,
commercial paper, mortgages, and
many other kinds of loans. In other
words, the bank puts your money to
work to keep the wheels of industry
and of agriculture turning around”.
Franklin D. Roosevelt

1. The Bank Balance Sheet

Banks obtain funds from their
Total Assets = Total Liabilities + Capital shareholders (equity capital)
and by borrowing and issuing
Assets (Uses of Funds) other liabilities such as
deposits.
Liabilities (External Sources of Funds) They then use these funds to
acquire assets such as
Capital (Equity = Shareholders Funds) securities and loans.
Bank Capital is defined as
Capital = Assets – Liabilities,
which implies that capital serves as a measure of net worth.
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The balance sheet of all US commercial banks at the
end of 2004
Assets (Uses of Funds) Liabilities (Sources of Funds)
Reserves and Cash Items 1 Checkable Deposits 9
Securities Non-transaction Deposits

U.S. Government and Agency 15 Small-denomination time deposits
State and Local Government and Other (<$100 000) and Saving Deposits 46
Securities 8 Large-denomination time deposits 15
Loans
Commercial and Industrial 8 Borrowings 24
Real Estate 29
Interbank 16
Other 3 Bank Capital 6
Physical Assets 20
Total 100 Total 100
Banks make profits by charging an interest rate on their holdings

of securities and loans that is higher than the expenses on their
liabilities.

The balance sheet of all US commercial banks at the
end of 2016
Source: Mishkin and Eakins (2016)
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Banking Business Models: A general approach
Source: Roengpitya et al. (2014)

1.1 Liabilities (Sources of Funds)
Checkable Deposits:
Checkable deposits are deposits in bank accounts that allow their owners to
write checks. 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. Similarly, if a
person who receives a check written on an account from a bank and
presents that check at the bank, it must pay the funds out immediately (or
credit them to that person’s account).
A checkable deposit is an asset for the depositor because it is part of his or
her wealth. Conversely, because the depositor can withdraw funds from an
account that the bank is obligated to pay, checkable deposits are liabilities
for the bank.
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Checkable deposits include:

- Demand deposits = checking accounts that (usually) pay no interest.
- Negotiable Order of Withdrawal (NOW) accounts = checking accounts
that pay interest.
- Money Market Deposit Accounts (MMDAs) = high-yielding deposit
accounts that allow limited check-writing privileges.
Checkable deposits are a bank’s lowest-cost source of funds, since depositors

are willing to accept a lower interest rate in exchange for the convenience of
being able to write checks.
But checkable deposits are also costly to maintain: the bank must process the
checks, prepare monthly statements, maintain bank branches, etc.

Non-transaction Deposits:
Owners cannot write checks on non-transaction deposits, but the interest
rates are usually higher than those on checkable deposits.
There are two basic types of non-transaction deposits: (1) saving deposits
and (2) time deposits (also called Certificates of Deposits or CDs).
(1) Savings deposits = funds can be withdrawn, without penalty, at any

time.
[Transactions and interest payments are recorded in a monthly statement or

in a small book (the passbook) held by the owner of the account.]
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(2) Time deposits or CDs
Small (in US: under $100,000) time deposits (also called Certificates of
Deposits or CDs) = have a fixed maturity, with penalty for early
withdrawal.
Large (in US: over $100,000) time deposits (also called Certificates of
Deposits or CDs) = also have a fixed maturity date, but they are negotiable,
meaning that they can be resold in a secondary market.
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Borrowings:
Borrowings include:
Borrowings from the Central Bank = discount loans (or advances).
Borrowings from other banks = interbank market funds.

[Banks also borrow reserves overnight from other banks and financial
institutions. Banks borrow funds overnight in order to have enough deposits
at the Central bank to meet the amount required by the Central Bank.]
Borrowings from non-bank corporations = repurchase agreements (repo).
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Bank Capital:
As noted before:
Capital = Assets - Liabilities = Net Worth.
And as we’ll see later, bank capital is a cushion against a drop in the value
of the bank’s assets, since the bank becomes insolvent (bankrupt) if the
value of its assets falls below the value of its liabilities (i.e., it owes more
than it can repay).
The funds are raised by selling new equity (stock) or from retained
earnings.
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1.2 Assets (Uses of Funds)
Reserves:
All banks hold some of the funds they acquire as deposits in an account at
the Central Bank. Reserves are these deposits plus currency that is
physically held by banks.
Reserves include:
- The bank’s deposits at the Central Bank.
- Vault cash = currency that is physically held by the bank.
Reserves do not pay interest. [From June 17, 2014, to September 13, 2022,
banks need to pay to Central Bank (-0.5%, from September 23, 2019)].
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Reserves: Banks hold reserves for two reasons:
First, some reserves, called required reserves, are held because of reserve
requirements, the regulation that for every euro of checkable deposits, a
certain fraction (say, 10 cents, for example) must be kept as reserves at the
Central Bank. This fraction (10% in the example) is called the required
reserve ratio.
Second, banks hold additional reserves, called excess reserves, because
they are the most liquidity of all bank assets and can be used by a bank to
meet its obligation when funds are withdrawn, either directly by a depositor
or indirectly when a check is written on an account.
Excess reserves = additional reserves held by the bank to meet its
customers’ requests for withdrawals.
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Cash Items in the Process of Collection:
A check that had been deposited at the bank, but not yet collected from the
check writer’s bank, is a cash item in the process of collection.
Deposits at Other Banks:

Many small banks hold deposits at larger banks.
Securities:
Securities include: Debt issued by governments, corporate bonds and other
securities.
[Because they are default-free and highly liquid,] a bank’s holdings of
short-term government securities (Treasury bills) are sometimes called
“secondary reserves”.
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Loans:
Banks make their profits primarily by issuing loans. A loan is a liability for
the individual or corporation receiving but it is an asset for a bank because
it provides income (interests) to the bank (and as well the right to receive
the principal). Loans are typically less liquid than other assets because they
cannot be turned into cash until the loan matures. Loans also have a higher
probability of default than other assets. Because of the lack of liquidity and
higher default risk, the bank earns its highest return on loans.
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Loans include:
- Commercial and industrial loans.
- Real estate loans (mortgages).
- Consumer loans.
- Interbank loans.
Other Assets:
Physical assets owned by banks: buildings and land, computers and office
equipment, etc.
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1.3 Equity Capital (Source of Funds)
Equity capital includes:
- Common stock (residual rights, dividend rights plus voting rights).
- Preferred stock (residual rights, preferential dividend rights without voting

rights).
- Retained earnings.
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2. Basic Operation of a Bank
By looking at their balance sheets, we can see that banks sell liabilities with
one set of characteristics and use the proceeds to acquire assets with a
different set of characteristics.
This process is called asset transformation.
By engaging in asset transformation, the bank hopes to profit by charging a

higher interest rate on its assets than it must pay on its liabilities.
To see how banks engage in asset transformation, let’s consider three

examples.
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Example 1
Suppose a customer deposits a €100 bill into his or her checking account at
Old Bank.
The bank puts the €100 bill in its vault and adds €100 to the customer’s
checking account balance.
The €100 deposit shows up as a new liability on Old Bank’s balance sheet,
while the extra €100 in vault cash adds to Old Bank’s reserves and
therefore shows up as a new asset.
Hence, the T-account looks like this:
Thus, when a bank receives
Assets Liabilities additional deposits, it gains an
equal amount of reserves.
Reserves +100 Checkable Deposits +100
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Example 2
Now suppose that instead of depositing a €100 bill, Old Bank’s customer
deposits a check for €100 written on an account at Citibank.
Hence, the T-account looks like this:
OLD BANK
Assets Liabilities
Cash Items in the Process of Collection +100 Checkable Deposits +100
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Example 2
Old Bank then deposits the check in its account at the Central Bank.
The Central Bank transfers €100 from Citibank’s account to Old Bank’s
account.
Now we can draw T-accounts for both Old Bank and Citibank:
OLD
Assets Liabilities
Thus, when a bank receives
Reserves +100 Checkable Deposits +100 additional deposits, it gains
an equal amount of
reserves.
CITIBANK
And when a bank loses
Assets Liabilities
deposits, it loses an equal
Reserves -100 Checkable Deposits -100
amount of reserves.
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Example 3
Consider Old Bank’s situation after it receives €100 in checkable deposits

and hence €100 in additional reserves.
By law, Old Bank must hold 10%, or €10, as required reserves.
The remaining €90 is excess reserves.

Assets Liabilities
Required Reserves +10 Checkable Deposits +100
Excess Reserves +90
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Example 3
Since reserves pay no interest, and since Old Bank is not required to hold
excess reserves, it may decide to use the €90 to make a new loan to one of
its other customers.
Assets Liabilities
Required Reserves +10 Checkable Deposits +100
Loans +90
If Old charges a 10% interest rate on this loan, its revenues increase by
€90×10%, or €9.
If Old pays only 5% on its checking account balances, its costs increase by
€100×5%, or €5.
Hence, Old Bank makes a profit from this process of asset transformation.
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3. General Principles of Bank Management
A bank manager has four basic concerns:
(i) Liquidity management = making sure that the bank has enough cash to
cover depositors’ requests for withdrawals (deposit outflows).
(ii) Asset management = acquiring assets with the highest return and the
lowest risk (efficient investment).
(iii) Liability management = acquiring funds at the lowest cost.
(iv) Capital adequacy management = maintaining sufficient capital while

still providing decent returns to shareholders.
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3.1 Liquidity Management
Example 1
Suppose that the required reserve ratio is 10%, but Old Bank holds some
excess reserves as well.
Old’s balance sheet is:
Assets Liabilities
Reserves 20 Checkable Deposits 100
Securities 10 Capital 10
Loans 80
Required reserves are €100 million×10% (= €10 million). Therefore, Old Bank has
€10 million in excess reserves. Now suppose that Old Bank experiences a deposit
outflow, either because one of its customers withdraws €10 million or because one
of its customers writes a check for €10 million on his or her account.
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As a result of this transaction, Old Bank loses €10 million in deposits and
€10 million in reserves. Old Bank’s balance sheet is now:
Assets Liabilities
Loans 80
Required reserves are €90 million×10% (€9 million). Old Bank is still meeting its
reserve requirement and, in fact, still has €1 million in excess reserves.
This example shows that by holding excess reserves, a bank can deal with a deposit outflow
without changing any other part of its balance sheet. In short, if a bank has ample reserves, a
deposit outflow does not necessitate change in other parts of its balance sheet.
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Example 2
Now suppose that the required reserve ratio is 10%, but Old Bank holds no
excess reserves.
This time, Old Bank’s balance sheet is:
Assets Liabilities
Loans 90
Required reserves are €100 million×10%, or €10 million. Hence, excess

reserves are €0.
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In such situation, if Old Bank experiences a €10 million deposit outflow, it

loses €10 million in deposits and €10 million in reserves.
Now it’s balance sheet is:
Assets Liabilities
Loans 90
By law, Old Bank must hold €90 million×10%, or €9 million, in required

reserves. But right now it has no reserves at all. Hence, Old Banks’s
manager must take action to obtain €9 million in reserves.
Old Banks has four
options.
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Option 1: Borrow reserves from another bank in the monetary market, or

borrow from a non-bank corporation by entering into a repurchase
agreement.
In this case, Old Banks’s balance sheet becomes:
Assets Liabilities
Securities 10 Borrowings 9
Loans 90 Capital 10
Both sides of the balance are changed.

The cost of choosing this option is the interest rate on the borrowing.
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Option 2: Sell securities.

In this case, Old Bank’s balance sheet becomes:
Assets Liabilities
Loans 90
In this case only the left side of the balance is changed.

The cost of choosing this option is the brokerage cost of selling securities
and potential liquidity costs (i.e., to sell the securities under fair value).
Also, the bank no longer gets the interest paid by the securities it sold.
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Option 3: A third way that the bank can meet a deposit outflow is to acquire
reserves by borrowing from the Central Bank. In our example, the Old
Bank could leave its security and loan holdings the same and borrow €9
million in discount loans from the Central Bank. Its balance sheet would
be:
Assets Liabilities
Loans 90 Discount Loans From
Securities 10 Central Bank 9
Capital 10
The cost of taking out a discount loan is the interest rate that must be paid
to Central Bank (called the discount rate).
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Option 4: Reduce its loans or selling off loans.

In this case, Old’s balance sheet becomes:
Assets Liabilities
Loans 81
Once again only the left side of the balance is changed.

This option may be the most costly of all. Selling loans (vg, through a
securitization process) is not easy and implies costs. Also, the bank no
longer gets the interest that would have been paid by the borrower.
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In conclusion, when a deposit outflows occurs, holding excess reserves

allows the bank to escape the costs of (1) borrowing from other banks or
corporations, (2) selling securities, (3) borrowing from the Central Bank, or
(4) or selling off loans.
Excess reserves are, therefore, insurance against the costs associated

with deposit outflows.
The higher the costs associated with the deposit outflows, the more excess
reserves banks will want to hold.
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3.2 Asset Management
The bank must hold a mix of assets that provides the highest return with the
lowest risk. Thus, asset management involves four basic principles:
1. Finding borrowers who will pay high interest rates but who are unlikely
to default.
2. Finding securities with high returns and low risk [High Sharp Ratio].
3. Diversifying the bank’s asset holdings to minimize risk: holding many
types of securities and making many types of loans offers protection when
there are losses in one type of security or one type of loan.
4. Holding some liquid assets, including excess reserves and Treasury bills
(“secondary reserves”), to protect against deposit outflows, even though the
interest rate on these assets may be lower.
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Sharpe Ratio
RA − RF
SA =
A
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Diversification
n
rp ,t =  R j ,t .w j ,t
j =1
n n n
 p2 =  covij .wi .w j =  i
2
.wi2 + 2 covij .wi .w j
i =1 j =1 i =1
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Diversification
i. Expected Return
N
E(R P ) =  X i R i
i =1
ii. Variation of Return (Risk)

If X = 1/N, first
 =  (X  ) +  (X i X j ij )
N N N
2 2 2 parcel tends to zero
P i i
i =1 i =1 j=1 when N tends to
i j
infinity
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3.3 Liability Management
Checkable deposits are a bank’s lowest-cost source of funds.
But checkable deposits are unlikely to provide a bank with all of the funds
that it needs.
Thus, the bank may obtain additional funds at higher costs by issuing CDs
or by borrowing from other banks or non-bank corporations (repurchase
agreements).
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3.4 Capital Adequacy Management
Capital = Assets - Liabilities = Net Worth

Banks have to make decisions about the amount of capital they need to hold
for three reasons.
First, bank capital helps prevent bank failure, a situation in which the bank
cannot satisfy its obligations to pay its depositors and other creditors and so
goes out of business.
Second, the amount of capital affects returns for the owners (equity
holders) of the bank.
And third, a minimum amount of bank capital (bank capital requirements)
is required by regulatory authorities.
z
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Example 1 [How Bank Capital Helps Prevent Bank Failure]
Consider two banks, one with high capital and the other with low capital.
Their balance sheets look like this:
HIGH CAPITAL BANK

Assets Liabilities
Loans 90 Capital 10
LOW CAPITAL BANK

Assets Liabilities
Loans 90 Capital 4
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Now suppose that both of these banks have made €5 million loans to a
company that goes bankrupt.
The value of loans at both banks falls by €5 million.
And since the value of their liabilities remains unchanged, both banks also
lose €5 million in capital.
HIGH CAPITAL BANK LOW CAPITAL BANK
Assets Liabilities Assets Liabilities
Reserves 10 Checkable Deposits 90 Reserves 10 Checkable Deposits 96
Loans 85 Capital 5 Loans 85 Capital -1
The high capital bank still has positive net worth. But the low capital bank
is insolvent (bankrupt).
This example shows how capital serves as a cushion against a drop in the
value of the bank’s assets.
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Example 2 [How the Amount of Bank Capital Affects Returns to Equity
Holders]
If capital is a cushion against a drop in the value of the bank’s assets, then
why don’t all banks have high capital?
To answer this question, let’s consider the high capital bank again, before
the €5 million loan went bad:
HIGH CAPITAL BANK
Assets Liabilities
Loans 90 Capital 10
LOW CAPITAL BANK

Assets Liabilities
Loans 90 Capital 4
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Example 2 [How the Amount of Bank Capital Affects Returns to Equity
Holders]
Suppose next that this bank receives €6 million in new deposits, but instead
of holding the €6 million as additional excess reserves, loaning the money
out, or buying securities, the bank decides to pay the €6 million out as an
extra dividend to its shareholders.
Now the bank’s balance sheet is:

HIGH CAPITAL BANK
Assets Liabilities
Loans 90 Capital 4
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This example shows that by lowering its level of capital, the bank can pay
more dividends to its shareholders.
Thus, the bank faces a trade-off:
By maintaining more capital, it protects itself against a decline in the value
of its assets.
But by maintaining less capital, it can pay more dividends and thereby
provide its shareholders with a better return on their investment.
How the Amount of Bank Capital Affects Returns to Equity Holders?
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How the Amount of Bank Capital Affects Returns to Equity Holders?
A basic measure of bank profitability is the return on assets (ROA), the

net profit after taxes per dollar of assets:
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠

𝑅𝑂𝐴 =
𝑎𝑠𝑠𝑒𝑡𝑠
The return on assets provides information on how efficiently a bank is

being run because it indicates how much profits are generated on average
by each euro of assets.
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However, what the bank’s owners (equity holders) care about most is how
much the bank is earning on their equity investment.
This information is provided by the other basic measure of bank

profitability, the return on equity (ROE), the net after taxes per dollar of
equity capital:
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠

𝑅𝑂𝐸 =
𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
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24

There is a direct relationship between the return on assets (which measures

how efficiently the bank is run) and the return on equity (which measures
how well the owners are doing on their investment). This relationship is
determined by the so-called equity multiplier (EM), which is the amount
of assets per dollar of equity capital:
𝐸𝑀 =
𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
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Therefore:
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑎𝑠𝑠𝑒𝑡𝑠

= 𝑥
𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
which yields
ROE = ROA x EM.
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Example:
As we have seen, the High Capital Bank initially has €100 million of assets
and €10 million of equity, which gives it an equity multiplier of 10 (=€100
million/€10 million). The Low Capital Bank, by contrast, has only €4
million of equity, so its equity multiplier is higher: 25 (=€100 million/€4
million).
Suppose that these banks have been equally well run so that they both have
the same return on assets of 1%. The return on equity for High Capital
Bank equals 1% x 10 = 10%, while the return on equity for the Low Capital
Bank equals 1% x 25 = 25%. We now see why owners of a bank may not
want it to hold a lot of capital. Given the return on assets, the lower the
bank capital, the higher the return for the owners of the bank.
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Trade-off Between Safety and Returns to Equity Holders:
Benefits for shareholders:

Capital makes their investment safer by reducing the likelihood of
bankruptcy.
Costs for shareholders:

The higher the capital is, the lower will be the return on equity for a given
return on assets.
Managers must decide how much of the increased safety that comes with
higher capital (the benefit) they are willing to trade off against the lower
return on equity that comes with higher capital (the cost).
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Exercise 1:
The manager of the Bank A has to make decisions about the appropriate
amount of bank capital. The current ratio of capital to assets is 10% (€10
billion of capital to €100 billion of assets). The manager is concerned that
the large amount of bank capital is causing the return on equity to be too
low. What can he or she do to increase the return on equity?
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Exercise 1:
The manager should increase the equity multiplier to increase the return on
equity. To lower the amount of capital relative to assets and raise the equity
multiplier, he or she can do three things:
(1) He or she can reduce the amount of the bank capital by buying back
some of the bank’s stocks.
(2) He or she can reduce the bank’s capital by paying out higher dividends
to its stockholders, thereby reducing the bank’s retained earnings.
(3) He or she can keep the bank capital constant but increase the bank’s
assets by acquiring new funds, for example, by issuing CDs, and then
seeking out loan business or purchasing more securities with these new
funds.
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Exercise 2:
Suppose that the Bank B has a low ratio of capital to assets of 3%. The
manager might worry that the bank is short on capital relative to assets
because it does not have a sufficient pillow to prevent bank failure. What
can he or she do to increase the ratio of capital?
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Exercise 2:
To raise the amount of capital relative to assets, he or she has the following
three choices:
(1) He or she can raise capital for the bank issuing new equity (common
stocks).
(2) He or she can raise capital by reducing the bank’s dividends to
shareholders, thereby increasing retained earnings that it can put into its
capital account.
(3) She can keep capital at the same level but reduce the bank’s assets by
making fewer loans or by selling off securities and then using the proceeds
to reduce its liabilities.
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Nowadays, Texas Ratio is widely used a measure of a bank's credit troubles.
Texas Ratio is the risk loans value over the total value of funds the bank has on hand
to cover these loans. At risk loans are any loans that are more than 90 days past due
and are not backed by the government. The amount of funds on hand consists of the
loan loss allowance that the bank has set aside plus any equity capital. That is:
𝑵𝒐𝒏 𝑷𝒆𝒓𝒇𝒐𝒓𝒎𝒊𝒏𝒈 𝑳𝒐𝒂𝒏𝒔

𝑻𝒆𝒙𝒂𝒔 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒍𝒍𝒐𝒘𝒂𝒏𝒄𝒆 𝒇𝒐𝒓 𝑳𝒐𝒂𝒏 𝑳𝒐𝒔𝒔𝒆𝒔 + 𝑬𝒒𝒖𝒊𝒕𝒚
The Allowance for Loan Losses (ALL), formerly known as the reserve for
bad loans, is a calculated “reserve” that financial institutions establish in
relation to the estimated credit risk within the institution’s assets. If is
necessary to increase the ALL, the bank needs to make provision for loan and
losses (PLL). Financial Institutions - Master in Finance - C. Alves - 2023-2024 57
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4. Off-Balance-Sheet Activities
Off-Balance-Sheet activities are activities which generate income, and
therefore affect bank profits and risk, but do not appear on bank balance
sheets.
Off-balance-sheet activities involving guarantees of securities and backup

credit lines increase the risk a bank faces. Even though a guaranteed
security does not appear on a bank balance sheet, it still exposes the bank to
default risk: If the issuer of the security defaults, the bank is left holding the
bag and must pay off the security’s owner. Backup credit lines also expose
the bank to risk because the bank may be forced to provide loans when it
does not have sufficient liquidity or when the borrower is a very poor credit
risk.
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Examples:
Guaranteeing debt securities such as banker’s acceptances (the bank
promises to make interest and principal payments if the party issuing the
security cannot).
Providing backup lines of credit. There are several types of backup lines
of credit. It is the case of loan commitment, under which for a fee the bank
agrees to provide a loan at the customer’s request, up to a given amount,
over a specified period of time.
Credit lines are also available to bank depositors with “overdraft
privileges” – these bank customers can write checks in excess of their
deposits and, in effect, write themselves a loan.
Trading Activities and Risk Management Activities
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Trading Activities and Risk Management Activities:
Bank’s attempts to manage interest-rate risk and currency risk led them to
trading in financial futures, options and interest rate swaps. All transactions
in these (derivatives) markets are off-balance-sheet activities because they
do not have a direct effect on the bank’s balance sheet.
Although bank trading in these markets is often directed toward reducing
risk or facilitating other bank business, banks also try to outguess the
markets and engage in speculation (vg, the failure of Barings, a British
Bank, in 1995).
Trading activities, although often highly profitable, are dangerous because
they make it easy for financial institutions and their employees to make
huge both easily and quickly.
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Trading Activities and Risk Management Activities:
Principal-Agent Problem: Given the ability to place large bets, a trader

(agent) has an incentive to take on excessive risks: If her trading leads to
large profits, she is likely to receive a high salary and bonuses, but if she
takes large losses, the financial institution (the principal) will have to cover
them.
[Lemons and Plums market]
61

To reduce the principal-agent problem, bank management must set up
internal controls to prevent debacles like one at Barings. Such controls
include:
(1) The complete separation of the people in charge of trading activities and
those in charge of bookkeeping for trades;
(2) Set up limits on total amount of trades and risk exposure;
(3) Adopting statistical models to assess and scrutinize risk (vg, Value-at-
Risk or VaR approach, which calculates the maximum loss that its portfolio
is likely to sustain over a given time period);
(4) Another approach is called “stress testing”. In this approach, the Bank
asks models what would happen if a doomsday scenario occurs; that is, it
looks at the losses it would sustain if an unusual combination of bad events
occurred.
62
31

Amount Share of Operating
5. Measuring Bank ($ billions) Income/Expenses (%)
Performance Operating Income

Interest income 335.7 64.3%
5.1 Bank’s Income Interest on loans

Interest on securities
265.9
54.1
50.9%
10.4%
Statement Other interest

Noninteres income
15.7 3.0%
Service charges on deposit accounts 31.7 186.5 6.1% 35.7%

Other noninterest income 154.8 29.6%
The end of year 2003 Total operating income 522.2 100.0%
income statement for Operating Expenses

Interest expenses 95.7 25.4%
all USA federally Interest on deposits
Interest on fed funds and repos
63.0
8.1
16.7%
2.2%
insured commercial Other
Noninterest expenses
24.6
246.0
6.5%
65.3%
banks is the Salaries and employee benefits
Premises and equipment
107.8
31.3
28.6%
8.3%
following: Other
Provisions for loan losses
106.9
34.8
28.4%
9.2%
Total operating expense 376.5 100.0%
Net Operating Income 145.7

Gains (losses) on securities issued 5.6
Extraordinary items, net 0.0
Income taxes -49.2
Net Income 102.1

63

Operating Income
Operating Income is the income that comes from a bank’s ongoing
operations. Most of a bank’s operating income is generated by interests on
its assets, particularly loans.
Noninterest income is generated by service charges on deposit accounts,
but the bulk of it comes from off-balance-sheet activities, which generate
fees or trading profits for the bank.
64
32

Operating Expenses
Operating Expenses are the expenses incurred in conducting the bank’s
ongoing operations. An important component of a bank’s operating
expenses is the interest payments that it must make on its liabilities,
particularly on its deposits.
Noninterest expenses include the costs of running a banking business:
salaries for officers, rent on bank buildings and, among others, servicing
costs of equipment such as computers.
The final item listed under operating expenses is the provision for loans
losses (PLL). When a bank has a bad loan (NPL – Non Performing Loan) or
anticipates that a loan might become a bad debt in the future, it can write
up the loss as a current expense in its income statement under the
“provision for loan losses” heading.
65

Income
Subtracting the $376.5 billion in operating expenses from the $522.2 billion
of operating income in 2003 yields net operating income of $145.7 billion.
Two items, gains (or losses) on securities sold by banks ($5.6 billion) and net
extraordinary items, which are events or transaction that are both unusual
and infrequent (insignificant) are added to net operating income to get the
net income before taxes (commonly referred as profits before taxes).
Subtracting the income taxes then results the $102.1 billion of net income
(commonly referred as profits after taxes).
66
33

The Direct Relationship Between the Income Statement and the Balance
Sheet
NI = Interest revenue – Interest expense – PLL + (NII – NIE) – T or
𝑁 𝑀
𝑁𝐼 = 𝑥 + 𝑎 𝑛 = ෍ 𝑟𝑛 𝐴𝑛 − ෍ 𝑟𝑚 𝐿𝑚 − 𝑃𝐿𝐿 + 𝑁𝐼𝐼 − 𝑁𝐼𝐸 − 𝑇

𝑛=1 𝑚=1
NI = Net Income
An = Value of the bank’s nth asset (€); Lm = Value of the bank’s mth liability
(€); rn = rate earned on the bank’s nth asset; rm = rate earned on the bank’s mth
liability; PLL = Provision for loan losses; NII = Noninterest income; NIE =
Noninterest expense; T = bank taxes; N = number of assets and M = number
of liabilities.
67

Exercise 3
Suppose that a bank has equity of €200M, interest expense of €90M, PLL =
€20M, net noninterest income of -€15M and a tax rate of 34%.
a) What is the minimum total interest revenue required to give a ROE of
15%? (Numbers in millions)
Required NI = NI/200 = 0.15 or NI = 30
NI = [Interest revenue– Interest expense – PLL + (NII – NIE)] × (1 – Tax
rate) or
30 = [Interest revenue – 90 – 20 – 15] × (1 – 0.34)
Required interest revenue = €170.45M.
68
34

b) If securities are €500M with an average rate of return of 5% and the bank
has €1500M in loans, which must be the average loan rate to generate
interest revenue of €170.45M?
170.45 = (500 × 0.05) + (1500 × Avg. Loan Rate). Avg. Loan Rate required =
9.7%.
69

Measures of Bank Performance

A basic measure of bank profitability that corrects for the size of the bank is
the return on assets (ROA).
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 102.1

𝑅𝑂𝐴 = = = 1.4%
𝑎𝑠𝑠𝑒𝑡𝑠 7292.8
The return on equity (ROE) is the net income per euro/dollar of capital. In
our example:
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 102.1
𝑅𝑂𝐸 = = = 15.3%
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 667.32
70
35

Financial Statement Analysis Using A Return on Equity Framework

Ratio analysis is very useful for [Chart of Ratios] Net Interest Income
Net Operating Income
identifying trends over time and Fees & Other Op. Income
Profit Margin Net Operating Income
for highlighting differences Net Income

Operating Margin Overhead Costs
from peer group competitors.
Impairments & PLL
a) Return on Equity and ROA
Net Income Income Taxes
Its Components Total Assets Net Operating Income
Net Interest Income
Operating margin (in Portuguese NetROE Income

Asset Utilization
Operating Margin
Total Assets
“Produto Bancário”) = operatingTotal Equity Capital Total Assets

Fees & Other Op. Income
income before overhead costs, Total Assets
Impairments & PLL = interest Equity Multiplier
margin + fees + gains Total Assets
Total Equity Capital
71

Financial Statement Analysis Using A Return on Equity Framework

b) Return on Assets and Its Components
Net Interest Income
Fees & Other Op. Income ROA is the product of the profit
Profit Margin Net Operating Income margin and asset utilization
Net Income ratios.
Operating Margin Overhead Costs
• The asset utilization ratio
measures how effectively the
Impairments & PLL bank converts its assets into
ROA gross operating revenues.
Net Income Income Taxes • The profit margin measures
Total Assets Net Operating Income how effectively the bank turns a
Net Interest Income euro of revenue into a euro of
Asset Utilization Total Assets bottom line profits.
Operating Margin
Total Assets
Fees & Other Op. Income
Total Assets
72
36

Example: CGD 2008
Net Interest Income 59.2%
Profit Margin 17.5% Fees & Other Operating Income 40.8% 100.0%
Overhead Costs 41.9%

ROA 0.50%
ROE 10.55% Impairments & PLL 36.4%
EM 21.06
Income Tax 4.2% 82.5%
Asset Utilization 2.9% Net Interest Income 1.7%
Fees & Other Operating Income 1.2% 2.9%
73

c) Other Ratios
Net interest margin (NIM)
Another commonly watched measure of bank performance is called the net
interest margin (NIM), the difference between interest income and interest
expenses as a percentage of total assets:
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑁𝐼𝑀 =
If a bank manager has done a good job of asset and liability management
such that the bank earns substantial income on its assets and has low costs on
its liabilities, profits will be high. The NIM will be high.
74
37

c) Other Ratios
The Spread
The spread measures the average yield on earning assets less the average cost
of interest bearing liabilities.
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑆𝑝𝑟𝑒𝑎𝑑 = −
𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Overhead Efficiency
𝑛𝑜𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Overhead Efficiency =
𝑛𝑜𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
75

Bibliography:
Mishkin, F. & Eakins, S., Financial Markets & Institutions, Person

International Edition. (Fifth Edition, Chapter 17)
76
38
Master in Finance
[2]
END
77
39

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Faculdade de Economia da Universidade do Porto

Carlos Francisco Alves

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 2

“First of all let me state the simple

Financial Institutions - Master in Finance - C. Alves - 2023-2024 3

Banking and the Management of

1. The Bank Balance Sheet

Financial Institutions - Master in Finance - C. Alves - 2023-2024 4

Banking and the Management of

Securities Non-transaction Deposits

Banks make profits by charging an interest rate on their holdings

Banking and the Management of

Source: Mishkin and Eakins (2016)

Financial Institutions - Master in Finance - C. Alves - 2023-2024 6

Banking and the Management of

Banking Business Models: A general approach

Source: Roengpitya et al. (2014)

Financial Institutions - Master in Finance - C. Alves - 2023-2024 7

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 8

Banking and the Management of

Checkable deposits include:

Checkable deposits are a bank’s lowest-cost source of funds, since depositors

Financial Institutions - Master in Finance - C. Alves - 2023-2024 9

Banking and the Management of

(1) Savings deposits = funds can be withdrawn, without penalty, at any

[Transactions and interest payments are recorded in a monthly statement or

Financial Institutions - Master in Finance - C. Alves - 2023-2024 10

Banking and the Management of

(2) Time deposits or CDs

Financial Institutions - Master in Finance - C. Alves - 2023-2024 11

Banking and the Management of

Borrowings from other banks = interbank market funds.

Borrowings from non-bank corporations = repurchase agreements (repo).

Financial Institutions - Master in Finance - C. Alves - 2023-2024 12

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 13

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 14

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 15

Banking and the Management of

Deposits at Other Banks:

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 17

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 18

Banking and the Management of

Equity capital includes:

- Common stock (residual rights, dividend rights plus voting rights).

- Preferred stock (residual rights, preferential dividend rights without voting

Financial Institutions - Master in Finance - C. Alves - 2023-2024 19

Banking and the Management of

This process is called asset transformation.

By engaging in asset transformation, the bank hopes to profit by charging a

To see how banks engage in asset transformation, let’s consider three

Financial Institutions - Master in Finance - C. Alves - 2023-2024 20

Banking and the Management of

Financial Institutions - Master in Finance - C. Alves - 2023-2024 21

Banking and the Management of

Hence, the T-account looks like this: