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Chapter 9
Banking and Management
of Financial Institutions
•
Because banking system plays a
major role in channeling funds from
the savers/lenders to
investors/borrowers, it is important to
study
1. how the banking system runs its
business to maximize its profit,
2. how and why banks make loans, and
3. how they acquire funds and manage
their assets and liabilities.
THE BANK BALANCE SHEET
• To understand how banking works we
start by looking at the bank balance
sheet.
• The bank balance sheet is a list of the
bank assets (what bank owns) and
liabilities (what it owes) where
total assets = total liabilities + bank’s
equity capital (net worth)
• Banks make profits by receiving
interest rates on their asset holdings of
securities and loans that is higher than
the expenses of their liabilities.
Liabilities
•
Liabilities are the sources of bank’s
funds. Banks obtain funds by
borrowing and by issuing (selling)
other liabilities such as deposits.
• Liabilities include
1. Checkable Deposits. They are bank
accounts that allow the owner of the
account to write checks to third
parties.
•
Checkable deposits include
1. non-interest bearing checking
account (demand deposits),
2. interest-bearing accounts (NOW
accounts: negotiable order of
withdrawal), and
3. money market deposit accounts
(MMDAs).
• MMDAs are not subject to reserve
requirements as checkable deposits
are, and are not included in the M1
definition of money.
• Checkable deposits and money market
deposit accounts are payable on
demand, which means if a depositor
shows up at the bank and requests
payment by making a withdrawal the
bank must pay him immediately.
Similarly, if a person who receives a
check written on an account from a
bank and presents that checks at the
bank, it must pay the funds out
immediately.
2. Non-transaction deposits. They are the
main source of bank funds. Owners
cannot write checks on nontransaction deposits, but the interest
rates paid on these deposits are
usually higher than those on
checkable deposits. There are two
basic types of non-transaction
deposits: saving accounts and time
deposits (also called CDs).
• Saving accounts, which funds can be
added to or withdrawn from at any time.
• Time deposits have a fixed maturity
length and charge high penalties for
early withdrawal. They are less liquid
than saving accounts but earn higher
interest rate.
3. Borrowings. Banks also obtain funds
by borrowing from the central bank,
other commercial banks, and
corporations.
4. Bank Capital. Bank capital or net
worth is the difference between total
assets and total liabilities. Bank
capital is raised by selling new equity
(stock) or retained earnings.
Assets
• Assets are the uses to which funds are
put.
• The funds obtained from issuing
liabilities are used to acquire incomeearning assets such as securities and
loans.
• Banks assets are the uses of funds,
and the interest earned on them are
what enable banks to make profit.
• Asset side of the balance sheet
includes
1. Reserves. Reserves include what
banks keep with central bank plus
currency (papers and coins) kept in
the bank vaults. Reserves are held for
two reasons:
• First, it is required by regulations.
Banks must keep a fraction (required
reserve ratio) of the money in their
checkable deposits as reserve. This is
called required reserves (RR).
•
Second, banks hold additional
reserves, called excess reserves (ER),
to meet obligations when funds are
withdrawn, directly by a depositors or
indirectly when a check is written on
an account.
2. Cash items in process of collection.
When a check written on an account
at another bank is deposited in your
bank and the funds for this check has
not been collected from the other
bank, it is an asset for your bank
because it is a claim on another bank
for funds that will be paid within a few
days.
3. Deposits at other banks
(corresponding banking). 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 purchase.
4. Securities. A bank’s holdings of
securities are an important incomeearning asset.
5. Loans. Banks make their profits
primarily by issuing loans. Because
of the lack of liquidity and higher
default risk, the bank earns its
highest return on loans.
6. Other Assets. The physical capital
(bank buildings, computer, and
other equipment) owned by the
banks is included in this category.
BASIC BANKING
• In general terms, banks make profits by
selling liabilities with one set of
characteristics (a particular
combination of liquidity, risk, size, and
return) and using the proceeds to buy
assets with a different set of
characteristics. This process is often
referred to as asset transformation.
• For example, a saving deposit held by
one person can provide the funds that
enable the bank to make a mortgage
loan to another person. The bank has,
in effect, transformed the saving
deposits (an asset held by the
depositor) to a mortgage loan (an asset
held by the bank).
• The process of transforming assets
and providing a set of services (check
clearing, record keeping, credit
analysis, and so forth) is like any other
production process in a firm.
• If the bank produces desirable services
at low cost and earns reasonable
income on its assets, it earns profits; if
not, the bank suffers losses.
• To make the analysis of the operation
of a bank more concrete, let us use a
tool called T-account.
• A T-account is a simplified balance
sheet, with lines in the form of a T, that
lists only the changes that occur in
balance sheet items starting from some
initial balance sheet position.
• For example, if you have just opened a
checking account with a $100 bill. You
have a $100 checkable deposit at a
bank (First Bank), which shows up as a
$100 liability on the bank balance
sheet. The bank now put your $100 bill
into its vault so that the bank’s assets
rise by the $100 increase in vault cash.
• The T-account for the First Bank looks like
this
Assets
Liabilities
Vault cash
+$100 Checkable deposits +100
• Because vault cash is part of reserves, we
can rewrite the T-account as follows
Assets
Reserves
+$100
Liabilities
Checkable deposits
+100
• Note that opening a new checking account
leads to an increase in the bank's reserves
equals to the increase in checkable deposits.
• Alternatively, suppose you had opened the
account with a $100 check written on an
account at another bank (the Second Bank),
we would get the same result. The initial
effect on the T-account of your bank (the
First Bank) is as follows:
Assets
Cash items in
+$100
process of collection
Liabilities
Checkable
deposits
+100
• To collect the fund of its customer (you)
from the Second Bank, the First bank
will deposit the check in its account
with the central bank, and the central
bank will collect the funds from the
Second Bank.
• When the central bank transfers the
$100 of reserves from the Second Bank
to the First Bank and the final balance
sheet position of the two banks are as
follows
Assets
Reserves
First Bank
Liabilities
$100 checkable deposits
Assets
Reserves
Second Bank
Liabilities
- $100
checkable deposits
$100
- $100
• When a bank receives additional deposits, it
gains an equal amount of reserves; when it
loses deposits, it loses an equal amount of
reserves.
• To make a profit, bank rearranges its balance
sheet when it experiences a change in its
deposits.
• As we know, the bank obliged to keep a
certain fraction of its checkable deposits as
required reserves (RR). This fraction is called
required reserves ratio (RRR). If the required
reserves ratio is 10%, the First Bank required
reserves have increased by $10.
First Bank
Assets
RR
ER
+ $10
+ $90
Liabilities
checkable deposits
$100
• To make a profit, the bank must put to
productive use all or part of the $90 of
excess reserves it has available.
• If the bank decides not to hold any excess
reserves but to make loans instead, the
T- account then looks like this
Assets
RR
Loans
First Bank
Liabilities
+ $10 checkable deposits
+ $90
$100
• The bank now is making 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.
• The above discussion has shown you
how a bank operates. Now let us see
how a bank manages its assets and
liabilities to earn the highest profit.
GENERAL PRINCIPLES OF
BANK MANAGEMENT
• The bank manager has five primary
concerns:
1. To make sure that the bank has enough
ready cash to pay its depositors when there
are deposit-outflows (because depositors
make withdrawals and demand payment).
To keep enough cash on hand, the bank
must engage in liquidity management, which
is the acquisition of sufficiently liquid assets
to meet the bank obligations to depositors.
2. To pursue an acceptable low level of
risk by acquiring assets which have a
low rate of default (credit risk) and by
diversifying asset holdings (asset
management).
3. To acquire funds at low cost (liability
management).
4. To decide the amount of capital the
bank should maintain and then
acquire the needed capital (capital
adequacy management).
5. To manage risks associated with
financial institution practices such as
interest-rate risk (the risk of earnings
and returns on bank assets that
results from interest-rate changes).
1. Liquidity Management and the
Role of Reserves
• To show how banks deal with deposit
outflows that occur when depositors
withdraw cash or write checks that are
deposited in other banks let us assume
that the bank has the following initial
balance sheet with RRR=10%
First Bank
Assets
Liabilities
Reserves
$20m Deposits
Loans
$80m Bank Capital
Securities $10m
$100m
$ 10m
• From the above information we can see that
the bank has ER=$10
• If a deposit outflow of $10 millions occurs,
the bank’s balance sheet becomes
Assets
Reserves
Loans
Securities
$10
$80
$10
Liabilities
Deposits
Bank Capital
$90
$10
• The bank loses $10m of deposits and $10m
of reserves.
• Its RR now is $9m and ER = $1m.
• The conclusion is that if the bank has ER, a
deposit outflow does not necessitate
changes in other parts of its balance sheet.
• The situation is quite different when a bank
does not hold ER
Assets
Reserves
Loans
Securities
Liabilities
$10 Deposits
$100
$90 Bank Capital $ 10
$10
• When the bank suffers the $10 million
deposit outflows, its balance sheet becomes
Assets
Reserves
Loans
Securities
Liabilities
$ 0 Deposits
$90
$90 Bank Capital $10
$10
• After $10 million has been withdrawn from
deposits and hence reserves, the bank has a
problem. The RR is $9 million, but the bank
has no reserves.
• To eliminate this shortfall , the bank has four
options
1. To borrow the $9 million from other banks
or corporations. The BS becomes
Assets
Reserves
Loans
Securities
•
$ 9
$90
$10
Liabilities
Deposits
$90
Borrowing from other
banks and corporations $ 9
Bank Capital
$10
The cost of this activity is the interest rate
on these borrowings.
2. To sell some of its securities to help cover
the deposit outflow.
For example, it might sell $9m of securities
and deposit the proceeds with the central
bank, resulting in the following BS
Assets
Reserves
Loans
Securities
•
$ 9
$90
$ 1
Liabilities
Deposits
Bank Capital
$90
$10
The bank incurs some brokerage and other
transaction costs when it sells these
securities.
3. To borrow $9 million in discount loans from
the central bank. Its BS now would be
Assets
Reserves
Loans
Securities
•
Liabilities
$ 9 Deposits
$90
$90 Borrowing from the
$10 central bank
$ 9
Bank Capital
$10
The cost associated with discount loans is
the interest rate that must be paid to the
central bank (called the discount rate).
4. To reduce the bank’s loans by $9 million
and deposit the amount with the central
bank. This transaction changes the BS as
follows
Assets
Reserves
Loans
Securities
$ 9
$81
$10
Liabilities
Deposits
Bank Capital
$90
$10
•
•
This process is the costliest way of
acquiring reserves because if the bank
refuses to renew the loans to some of its
customers this will upset them and may
take their businesses away from the bank.
And if the bank sells some of the loans off
to other banks, these loans will be sold
lower than their full value
•
The above discussion explains why banks
hold ER even though loans or securities
earn a higher return.
• When a deposit outflow occurs, holding ER
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) calling in or selling off loans.
•
ERs are insurance against the costs
associated with deposit outflows.
• A bank is willing to pay the cost of holding
ER (the opportunity cost, the earnings
forgone by not holding income-earning
assets such as loans or securities) to insure
against loses due to deposit outflows.
• Because ERs have a cost, banks also take
other steps to protect themselves; for
example, they might shift their holdings of
assets to more liquid securities (secondary
reserves).
2. Asset Management
• To maximize its profits, a bank must
simultaneously seek
(1) the highest returns possible on loans and
securities,
(2) reduce risk, and
(3) have efficient liquidity management.
• In order for banks to accomplish these three
goals, they follow a strategy of asset
management that can be summarized in the
following four basic ways.
1. Banks try to find borrowers who will pay
high interest rates and are unlikely to
default.
Loans officers engage in screening of the
potential borrowers to reduce the adverse
selection process.
2. Banks try to purchase securities with high
returns and low risk.
3. Banks must attempt to lower risk by
diversifying their assets, and making
different types of loans to different types of
customers.
4. Banks must manage the liquidity of their
assets so that they can satisfy reserves
requirements without bearing huge costs.
This means that banks will hold some
securities that are more liquid even if they
earn somewhat lower return than other
assets.
The bank must balance its desire for
liquidity against the increased earnings
that can be obtained from less liquid assets
such as loans.
3. Liability Management
• Banks aggressively set target goals for their
asset growth and tried to acquire funds by
issuing liabilities as they were needed.
• For example, when a bank finds an attractive
loan opportunity it can acquire funds by
selling negotiable CDs or through borrowing
from the central bank fund market.
• Because of the increased flexibility and
importance of liability management, most
banks now manage both sides of the balance
sheet together in an asset-liability
management (ALM) committee.
4. Capital Adequacy Management
•
Banks have to make decisions about the
amount of capital they need to hold for
three reasons.
1. Bank capital helps prevents bank failure,
a situation in which the bank cannot
satisfy its obligations to pay its
depositors and other creditors.
2. The amount of capital affects returns for
the owners (equity-holders) of the bank.
3. A minimum amount of bank capital (bank
capital requirements) is required by
regulatory authorities.
How Bank Capital Helps Prevent Bank Failure?
• Let us consider two banks with identical
balance sheet except that the High Capital
Bank has a ratio of capital to assets of 10%
while the Low Capital Bank has a ratio of
4%.
Assets
Reserves
Loans
High Capital Bank
Liabilities
$10 Deposits
$90
$90 Bank Capital
$10
Assets
Reserves
Loans
Low Capital Bank
Liabilities
$10 Deposits
$96
$90 Bank Capital
$ 4
• Suppose a $5 million of bad loans to both
banks are written off (valued at zero), the
total value of assets declines by $5 million.
• As a consequence, bank capital, which
equals total assets minus liabilities, also
declines by $5 million. The balance sheets of
the two banks look like this.
Assets
Reserves
Loans
High Capital Bank
Liabilities
$10 Deposits
$90
$85 Bank Capital
$ 5
Assets
Reserves
Loans
Low Capital Bank
Liabilities
$10 Deposits
$96
$85 Bank Capital - $ 1
• The High Capital Bank still has a positive net
worth (bank capital) of $5 million after the
loss.
• The value of Low Capital Bank’s assets has
fallen below its liabilities and its net worth is
now -$1 million. It does not have sufficient
assets to pay off all holders of its liabilities
(creditors). So, it is insolvent and
government regulators will close the bank.
• A bank maintains capital to lessen the
chance that it will become insolvent.
• How the Amount of Bank Capital
Affects Returns to Equity Holders?
• Because owners of a bank must know
whether their bank is being managed well,
they need good measures of bank
profitability.
• A basic measure of 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 dollar of assets.
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 profit after
taxes per dollar of equity (bank) capital.
net profit after taxes
ROE 
equity capital
• There is a direct relationship between
the return on assets (which measure
how efficiently the bank is run) and the
return on equity (which measure 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
assets
EM 
equity capital
• To see this, we note that:
net profit after taxes net profit after taxes
assets


equity capital
assets
equity capital
Which yields, ROE = ROA x EM
• Therefore, given the return on assets, the lower
the bank capital the higher the returns for the
owners of the bank.
• Bank capital benefits the owners of a bank in
that it makes their investment safer by reducing
the likelihood of bankruptcy.
• Bank capital is costly because the higher it is
the lower will be the return on equity for a
given return on assets.
• In determining the amount of bank capital,
managers must decide how much of the
increased safety that comes with higher
capital they are willing to trade off against
the lower return on equity that comes with
higher capital.
• In more uncertain times, when the possibility
of large losses on loans increases, bank
managers might want to hold more capital to
protect the equity holders.
• Conversely, if they have confidence that loan
losses won’t occur, they might want to
reduce the amount of capital, have a high
equity multiplier, and thereby increase the
return on equity.
5. Managing Credit Risk
• Banks and other financial institutions make
loans that must be paid back in full. The
possibility of default subjects the financial
institutions to credit risk.
• The economic concepts of adverse selection
and moral hazard provide a framework for
understanding the principles that financial
institutions have to follow to reduce credit
risk and make successful loans.
• Adverse selection in loan markets occurs
because bad credit risks (the 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.
• Borrowers with very risky investment
projects have much to gain if their projects
are successful. However, they are the least
desirable borrowers because of the greater
possibility that they will be unable to pay
back their loans.
• Moral hazard exists in loan markets because
borrowers may have incentives to engage in
activities that are undesirable from the
lenders point of view. In such situations, it is
more likely that the lender will be subjected
to the hazard of default.
• To be profitable, financial institutions must
overcome the adverse selection and moral
hazard problems that make loan defaults
more likely.
• The attempts of financial institutions to solve
these problems help explain a number of
principles for managing credit risk such as
(1)screening and monitoring, (2)
establishment of long-term customer
relationships, (3) loan commitments, (4)
collateral and compensating balance
requirements, and (5) credit rationing.
Screening and Monitoring
• Asymmetric information is present in loan
markets because lenders have less
information about investment opportunities
and activities of borrowers than borrowers
do. This situation leads to two informationproducing activities by banks and other
financial institutions: screening and
monitoring.
Screening
• Adverse selection in loan markets requires
that lenders screen out the bad credit risks
from the good ones so that loans are
profitable to them.
• To accomplish effective screening, lenders
must collect reliable information from
prospective borrowers.
• Effective screening together with information
collection form an important principle of
credit risk management.
• The lender uses the information collected
from the various forms the borrowers filled in
to evaluate how good a credit risk you are by
calculating your credit score, a statistical
measure derived from your answers that
predicts whether you are likely to have
trouble making your loan payments.
• Deciding on how good a risk you are cannot
be entirely scientific. Personal judgment of
the loan officer that is based on the
experience and other factors is also
important.
Specializing in lending
• Banks often specialize in lending to local
firms or to firms in particular industries. It
looks like the bank is not diversifying its
portfolio of loans and thus exposing itself to
more risk.
• However, the adverse selection problem
requires the bank to screen out bad credit
risk.
• It is easier for the bank to collect information
about local firms and determine their
creditworthiness than doing the same thing
for firms far away.
• Similarly, by concentrating its lending on
firms at specific industries, the bank
becomes more knowledgeable about these
industries and is therefore better able to
predict which firms will be able to make
timely payments on their debts.
Monitoring and Enforcement of Restrictive
covenants
• Once a loan has been made, the borrower
has an incentive to engage in risky activities
that make it less likely that the loan will be
paid off.
• To reduce this moral hazard, financial
institutions (the lenders) should write
provisions (restrictive covenants) into loan
contracts that restrict borrowers from
engaging in risky activities.
• By monitoring borrowers activities to see
whether they are complying with the
restrictive covenants and by enforcing the
covenants if they are not, lenders can make
sure the borrowers are not taking on risks at
their expense.
• The need for banks and other financial
institutions to engage in screening and
monitoring explains why they spend so
much money on auditing and informationcollecting activities.
Long-Term Customer Relationship
• Another principle of credit risk management
is to establish a long-term relationship with
customers. This allows banks and other
financial institutions to obtain information
about their borrowers.
• If a prospective borrower has had an account
with or loans from a bank over a long period
of time, a loan officer can look at past activity
on the accounts and learn quite a bit about
the borrower.
• The long-term customer relationships reduce
the costs of information collection and make
it easier to screen out bad credit risks.
• LT customer relationships enable banks to
deal with even unanticipated moral hazard
contingencies. The borrower has the
incentive to avoid risky activities that would
upset the bank in order to preserve a longterm relationship with the bank, which will
make it easier to get future loans at low
interest rates. This behavior benefits both
the bank and the customer.
Loan Commitments
• Banks also create long-term relationships
and gather information by issuing loan
commitments to commercial customers.
• A loan commitment is a bank’s commitment
for a specified future period of time to
provide a firm with loans up to a given
amount at an interest rate that is tied to some
market interest rate.
• The majority of commercial and industrial
loans are made under the loan commitment
arrangement.
• The advantage for the firm is that it has a
source of credit when it needs it.
• The advantage for the bank is that the loan
commitment promotes a long-term
relationship, which in turn facilitates
information collection.
• A loan commitment agreement is a powerful
method for reducing the bank’s costs for
screening and information collection.
Collateral and Compensating Balances
• Collateral requirements for loans are
important credit risk management tools.
• Collateral is property promised to the lender
as compensation if borrower defaults.
• It lessens the consequences of adverse
selection because it reduces the lender’s
losses in the case of loan default. If a
borrower defaults on a loan, the lender can
sell the collateral and use the proceeds to
make up for it losses on the loan.
• One particular form of collateral required
when a bank makes commercial loans is
called compensating balances.
• Compensating balances means that when a
firm receives a loan it must keep a required
minimum amount of funds in a checking
account at the bank.
• By requiring the borrower to use a checking
account at the bank, the bank can observe
the firm’s check payment practices, which
may yield a great deal of information about
the borrower’s financial condition.
6. MANAGING INTEREST RATE RISK
• Interest-rate risk refers the risk of earnings
and returns that is associated with changes
in interest rates.
• To see what interest-rate risk, let’s look at the
balance sheet of the First Bank
Assets
Rate-sensitive assets $20
Variable-rate and
short-term loans
Short-term securities
Fixed-rate assets
$80
$50 Reserves
Long-term loans
Long-term securities
Liabilities
Rate-sensitive liabilities$50
variable-rate CDs
Money market deposit
Accounts
Fixed-rate liabilities
Checkable deposits
Saving deposits
Long-term CDs
Equity capital
• Rate-sensitive: when interest rates change
frequently (at least once a year)
• Fixed-rate: when interest rates remain
unchanged for a long period (over a year)
• Suppose the interest rates rise by 5%. The
income on assets increase by $1 million (=
5% X $20 million of rate-sensitive assets),
while payments on liabilities increase by
2.5 million (= 5% x $50 million of ratesensitive liabilities). Thus, the profits of the
First Bank now decline by $1.5 million
($1m – $2.5m).
• Conversely, if interest rates fall by 5%, the
bank’s profits will increase by $1.5m.
• The conclusion is that 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 increase
bank profits.
Gap and Duration Analysis
• The sensitivity of bank profits to changes in
interest rates can be measured more directly
using gap analysis and /or duration analysis.
• Gap analysis refers to the difference between
the rate-sensitive assets and rate-sensitive
liabilities. In our example, the gap is $20m –
$50m = -$30m.
• By multiplying the gap times the change in
the interest rate we can immediately obtain
the effect on bank profits. For example, when
interest rates rise by 5% the change in profits
is 5% x -$30m, which equals -$1.5m.
• Duration Analysis examines the sensitivity of
the market value of bank’s total assets and
liabilities to changes in interest rates.
• Duration analysis involves using the average
(weighted) duration of a financial institution’s
assets and liabilities to see how the net
worth responds to a change in interest rates.
• Suppose the average duration of the First
Bank’s assets is 3 years (the average
lifetime of stream of payments in 3 years),
and the average duration of its liabilities is
2 years. In addition, the bank has a$100m
of assets and $90m of liabilities. Thus the
bank capital is $10m (10% of the assets).
With a 5% increase in interest rate, the
market value of the bank’s assets falls by
15% (= -5% x 3). However, the market
value of the liabilities falls by 10% (= -5% x
2). Hence, the net worth has declined by
5% of the total original asset value.
• Similarly, a 5% decrease in interest rates
increase the net worth of the bank by 5%
of the total asset value.
• Both gap analysis and duration analysis
indicate that the First Bank will suffer if
interest rates rise but it will gain if they fall.