Download Ch#18 Bank Management

Ch#19 Bank Management
• The underlying goal behind managerial policies is to
maximize shareholders wealth.
• Banks can incur agency costs.
• It may become a take over target.
• It can avoid agency costs by providing stocks as
compensation to managers.
• Bank’s directors oversee the operations of the bank and
perform the following important functions:
1. To determine a compensation system for executives
2. To ensure proper disclosure of financial condition and
performance to investors
3. Growth strategies such as acquisitions
4. Policies for capital structuring including decisions to raise
capital or to repurchase stocks
5. To assess the bank’s performance and to ensure that
correct action is taken in case of poor management.
Managing Liquidity
• Banks can experience illiquidity when cash outflows exceed
cash inflows.
• They can resolve any cash deficiency either by creating
additional liabilities or by selling assets.
• Since some assets are more marketable than others in the
secondary market, the bank’s asset composition can affect
its degree of liquidity.
• At an extreme, banks could assure sufficient liquidity by
using most of their funds to purchase treasury securities.
Use of securitization to Boost
Liquidity
• The process of securitization commonly involves the
sale of assets by the banks to a trustee, who issues
securities that are collateralized by the assets.
• Banks are more liquid as a result of securitization
because they effectively convert future cash flows into
immediate cash.
• The process involves a guarantor who, for a fee,
guarantees future payments to investors
Managing Interest Rate Risk
• The composition of banks balance sheet will determine how its
profitability is influenced by interest rate fluctuations.
• If a bank expects interest rates to consistently decrease over time, it will
consider allocating most of its funds to rate insensitive assets, such as
long-term and medium-term loans as well as long-term securities.
• If a bank expects interest rates to consistently increase over time, it will
consider allocating most of its funds to rate sensitive assets such as short
term commercial and consumer loans, long term loans with floating
interest rates, and short term securities.
• A major concern of banks is how interest rate movements will affect
performance, particularly earning
Managing Interest Rate Risk
• A more formalized comparison of the banks interest revenues and
expenses is provided by the net interest margin, computed as
• Net interest Margin = Interest revenues – Interest expense
Total Assets or Earning Assets
• The change depends on whether the bank’s assets are more or less
rate sensitive than bank liabilities, the degree of difference in rate
sensitivity, and the direction of interest rate movements.
• During a period of rising interest rates a bank’s net interest margin
will likely decrease if its liabilities are more rate sensitive than its
assets.
Example
Suppose a large international bank records $4
billion in interest revenues from its loans and
security investments and $2.6 billion in
interest expenses paid out to attract deposits
and other borrowed funds. If the bank holds
$40 billion in earning assets, What is its net
interest margin?
Methods to Assess Interest Rate Risks
1. Gap Measurement ( Asset Liability
Management)
2. Duration Measurement
3. Sensitivity of performance to interest rate
movements
Gap Measurement
• Control over the difference between the volume of a Bank’s interest
sensitive (repriceable) assets and the volume of its interest sensitive
(repriceable) liabilities.
• Dollar amount of repriceable
• (Interest-sensitive) bank
•
Assets
Dollar amount of repriceable
=
(Interest-sensitive) bank
Liabilities
• Gap =
–
Rate-sensitive Assets
Rate-sensitive Liabilities
• A gap of zero suggests that rate-sensitive assets equal rate-sensitive
liabilities, so that net interest margin should not be significantly influenced
by interest rate fluctuations.
Gap Measurement
• Assets sensitive (Positive) gap :
= Interest sensitive Assets > Interest sensitive
Liabilities
• Liability sensitive
(Negative) gap :
= Interest sensitive Assets - Interest sensitive
Liabilities
• Interest Sensitive ratio
=
ISA / ISL
Example
• Suppose Carroll Bank and Trust reports interest
sensitive assets of $570 million and interest
sensitive liabilities of $685 million. What is the
bank’s interest sensitive gap and gap ratio? Is the
bank asset or liability sensitive? The interest
revenue of the bank is $90 million while interest
expense is $40 million. The total assets of the
bank are $1 billion. If the bank forecasts an
increase in interest rate, how would its net
interest margin change?
Duration Measurement
A measure of the maturity and value sensitivity of a financial asset that
considers the size and the timing of all its expected cash flows
• D
•
•
= Σ Expected CF in Period t * Period t / (1+ YTM) t
Expected CF in Period t
(1+YTM) t
• The duration of the zero-coupon bond is always equal to the bonds
maturity, where as that of coupon bond is always less than the bonds
maturity.
• Instead of finding duration of individual asset/liability, bank and other FI
find duration of asset and liability portfolio. The duration of an
asset/liability portfolio is equal to the weighted average duration of
individual components in that portfolio.
Example
• A bond with $1000 par value is offering an 8%
coupon rate with a yield to maturity of 14%
and three years left to maturity. What is the
duration?
• Find duration if it was a zero coupon bond?
Sensitivity to interest rate movements
• A common proxy for performance is return on assets,
return on equity, or the percentage change in stock
price.
• ROA =
NI
TA
• ROE
=
NI
OE
Methods to Reduce interest Rate Risk
1.
2.
3.
4.
5.
Maturity matching
Using floating-rate loans
Using financial futures contracts
Using interest rate swaps
Using interest rate caps
•
Maturity Matching
•
Using floating-rate Loans
•
An alternative solution is the use of the floating rate loan, which allows banks to
support long-term assets with short-term deposits without overly exposing
themselves to interest rate risk.
•
If the cost of funds is changing on a more frequent basis than the rate on assets,
the bank’s net interest margin is still affected by interest rate fluctuations.
•
When banks reduce their exposure to interest rate risk by replacing long-term
securities with more floating rate commercial loans, they increase their exposure
to default risk, since the commercial loans provided by banks typically have a
higher frequency of default than securities held by banks.
• Using Financial Futures Contracts
• Another method of reducing interest rate risk is to use financial futures
contracts, which lock in the price at which specified financial instruments
can be purchased or sold on a specified future settlement date.
• So Futures are Contracts that call for the future sale or purchase of
specific types of financial assets at a fixed price to profit or hedge against
loss
• For example, there are future contracts available on CDs. When banks lock
in the price at which they can sell CDs for a particular settlement date, this
effectively locks in their cost of obtaining these funds. Consequently, their
overall cost of future funds is somewhat insulated from interest rate
movements.
Using interest Rate Swaps
•
A contract between two parties to exchange interest payments in an effort to save money and
hedge against interest rate risk
•
A way to change an institution’s exposure to interest rate fluctuations and achieve lower borrowing
costs
•
The interest rate swap has been especially useful for savings institutions whose liabilities are more
rate sensitive than their assets.
•
A bank’s whose liabilities are more interest sensitive than its assets can swap payments with a fixed
interest rate in exchange for payments with a variable interest rate over a specified period of time.
•
If interest rate rises, the bank benefits because the payment to be received will increase while its
outflow payments are fixed.
•
An interest rate swap requires another party that is willing to provide variable-rate payments in
exchange for fixed rate payments.