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CHAPTER 14
BANK MANAGEMENT AND PROFITABILITY
CHAPTER OVERVIEW AND LEARNING OBJECTIVES
 The previous chapter described what banks do to earn profits. This chapter examines some
issues arising in the pursuit of those profits.
 The chapter describes bank income statements in terms of primary sources of income and
expense, recent trends in bank earnings and performance, and key measures of bank performance.
 The chapter explains the dilemma of bank profitability versus bank safety and how managers
manage various risks while they attempt to maximize shareholder wealth. Major topics covered
are liquidity risk, interest rate risk, credit risk, and capital requirements.
CAREER PLANNING NOTE: THREE NATIONWIDE EMPLOYERS IN BANKING
Name
Ticker
Careers Website
Bank of America
Citigroup
JPMorgan Chase
BAC
C
JPM
http://careers.bankofamerica.com/overview/overview.asp
http://careers.citigroup.com/careers/homepage/default.aspx
http://careers.jpmorganchase.com/career/careerhome
READING THE WALL STREET JOURNAL: THE OP-ED PAGES
The opinion/editorial pages are at the back of Section A. Here you will find a range of commentary by
preeminent figures in business, government, and the press about a range of national issues.
TOPIC OUTLINE AND KEY TERMS
I.
Bank Earnings: Interest Income – Interest Expense – Provision for Loan Losses +
Noninterest Income – Noninterest Expense
A.
Gross Interest (and fee) income on loans and securities.
1.
The major source of income for commercial banks is interest (and fees) on loans.
a.
4.08% of industry assets in 2006.
b.
More significant for small banks than large banks.
(1)
Small banks tend to make more real estate and agricultural loans.
(2)
Large banks tend to make more commercial and
2.
Next after loan income is interest from investment securities (more significant for
small banks than large banks).
industrial loans.
B.
Gross interest expense on deposits and other borrowings.
1.
Interest on deposits is a major expense for banks.
a.
b.
1.71% of industry assets in 2006.
More significant for small banks than large banks.
(1)
Small banks rely more on deposits than large banks
(2)
Large banks rely more on Fed funds and other nondeposit
sources
2.
C.
Net Interest Margin: Gross Interest Income – Gross Interest Expense
1.
2.
D.
and
The “gross profit” of a commercial bank.
Larger as percentage of industry assets for small banks than for large banks.
a.
For small banks, averages 3.72% of assets.
(1)
Small banks tend to make more real estate and agricultural loans
(2)
Small banks rely more on demand deposits
b.
For large banks, averages 2.70% of assets,
(1)
Large banks tend to make more commercial and industrial loans
(2)
Large banks rely more on time deposits and nondeposit sources
Provision for loan losses: An expense item that adds to a bank’s loan loss reserve.
1.
2.
E.
Gross interest expense on all borrowings: about 2.61% of industry assets.
The loan loss reserve is a “contra” account deducted from gross loans.
Banks add to their loan loss reserve in anticipation of credit quality problems in
their loan portfolio.
Noninterest Income and Expense.
1.
Noninterest income has grown in importance, especially for large banks.
a.
About 2.16% of industry assets in 2006.
b.
Examples of noninterest income include—
(1)
Service charges and NSF charges on demand deposits
(2)
Fees for other bank services (safe deposit, wire transfer, etc.)
(3)
ATM surcharges
(4)
Commissions on investment and insurance products
(5)
Credit card annual fees
2.
Noninterest expense has generally leveled off with automation, consolidation,
economies of scale.
a.
About 2.88% of industry assets.
b.
Examples of noninterest expense include
(1)
Personnel (small banks are more labor-intensive than large
banks)
(2)
(3)
(4)
(5)
II.
Technology (large banks are more automated than small banks)
Occupancy
Administration and Compliance
Marketing
Bank Performance: Return on Average Assets; Return on Average Equity.
A.
ROAA: Return on Average Assets = Net Income / Average Assets.
1.
The key ratio in evaluating quality of bank management.
2.
Tells how well management can exploit a given amount of assets.
3.
Industry average is recently around 1.4%.
B.
ROAE: Return on Average Equity = Net Income / Average Equity Capital.
III.
1.
Tells shareholders how well management has employed their capital.
2.
Industry average is recently around 13% (banks are highly leveraged).
Bank Management’s Dilemma: Profitability vs. Safety (“Eat well or sleep well”).
A.
B.
Three constituencies: shareholders, depositors, regulators.
1.
Shareholders may sell their stock if bank managers do not generate adequate
profits, driving the bank’s stock price lower.
2.
Depositors (especially uninsured ones) may withdraw their balances if bank
managers take on too much risk, creating a liquidity crisis for the bank.
3.
If regulators believe that management is imprudent, they may intervene in the
management of the bank or even revoke its charter.
Banks can fail in either of two ways: Insolvency or illiquidity.
1.
Insolvency: Insufficiency of assets to cover liabilities.
a.
Banks are highly leveraged; they lack the equity “cushion” of other
firms.
b.
2.
IV.
Assets lose value if banks accept too much credit risk or interest rate risk.
Illiquidity: Insufficiency of available funds to cover promised disbursements.
a.
The most liquid assets also tend to be the least profitable.
b.
Yet disbursement demand must be accommodated:
(1)
Withdrawals by depositors
(2)
Loan proceeds to borrowers
(3)
Payments to employees, suppliers, and creditors
c.
Even profitable banks can fail if they become illiquid.
Liquidity Management: Both sides of the Balance Sheet.
A.
Objectives of Liquidity Management
1.
Hold enough “primary reserves” (defined below) to satisfy reserve requirements.
2.
Hold minimum primary and secondary reserves consistent with bank safety.
3.
Minimize opportunity cost of foregone interest on liquid assets.
B.
Sources of liquidity:
1.
New deposits
2.
New nondeposit borrowings (e.g. Fed funds)
3.
Loan repayment
4.
Sale of investment securities
5.
Participation or securitization of loans
6.
Sale of other assets
7.
New equity capital
C.
Liquidity requirements:
1.
Meet reserve, clearing, and settlement requirements at Fed
2.
Accommodate deposit withdrawals
3.
Pay other liabilities and expenses as they become due
4.
Accommodate loan requests
D.
Asset management classifies bank assets into four basic groups.
1.
Primary Reserves are the cash assets on a bank’s balance sheet.
a.
b.
c.
E.
by
V.
Immediately available at no cost, but
Yield no interest, so banks try to minimize holdings of primary reserves.
Primary reserves include—
(1)
vault cash
(2)
correspondent balances at other banks
(3)
excess reserve balances at the Fed
2.
Secondary Reserves are short-term assets convertible quickly to cash at a price
near their purchase price.
a.
Highly marketable with low default risk or price risk, but
b.
Yield little interest compared to loans or riskier investments.
c.
Secondary reserves include—
(1)
Treasuries
(2)
agencies
(3)
reverse repurchase agreements
3.
Loans (and leases) are generally less liquid and riskier than other bank assets and
thus represent the most potentially profitable use of bank funds.
4.
Other Investments include securities purchased chiefly for their income or tax
benefits, rather than their liquidity (e.g. municipal bonds).
Liability management supplements asset management but does not supersede it.
1.
Liability Management Theory assumes certain types of bank liabilities are very
sensitive to interest rate changes.
a.
By raising the rate on these liabilities above the market rate, a bank
should immediately attract additional funds.
b.
By lowering the rate, a bank should be able to “run off” funds as the
liabilities mature.
c.
“Money Market” strategy, attempted more by large banks.
2.
Bank liabilities used in liability management include—
a.
Negotiable CDs
b.
Fed funds
c.
Repurchase agreements
d.
commercial paper
e.
Eurodollar borrowings
3.
Three possible uses of liability management:
a.
Counteract deposit inflows and outflows and reduce their variability.
Sudden or unexpected deposit outflows can be offset immediately by
purchase new funds.
b.
Meet increased loan demand. If expected marginal return on new loans
exceeds expected marginal cost of funds, the bank can increase income
funding additional loans through liability management.
c.
Immediately honor funding commitments triggered by off-balance-sheet
contingencies. Banks with access to liability management mechanisms
can make contingent commitments confidently.
Capital Management.
A.
Roles of Bank Capital
1.
Financial cushion that enables banks to absorb temporary operating losses.
2.
3.
4.
B.
Capital Adequacy Regulation
1.
VI.
Helps maintain public confidence in soundness banks and banking system.
Provides some protection for uninsured depositors.
Source of funds for growth (new products, services, or facilities).
Basel I (Basel Accords on risk-based capital standards, 1988)
a.
Regulatory definition of bank capital: Tier 1, Tier 2
(1)
Tier 1 Capital or “core capital”
i.
common stock
ii.
paid-in surplus
iii.
undivided profits
iv.
noncumulative perpetual preferred stock
v.
minority interest in consolidated subsidiaries less
intabgibles
(2)
Tier 2 Capital or “supplemental capital”
i.
cumulative perpetual preferred stock
ii.
loan loss reserves
iii.
subordinated debt
iv.
mandatory convertible debt
v.
other “hybrid” debt
b.
Risk-weighting of assets
(1)
Riskier assets receive higher weights
(2)
Safer assets receive lower weights
(3)
Conversion factors for off-balance-sheet items (Exhibit 14.10)
bring percentage of items “on to” balance sheet for riskweighting purposes
c.
Minimum capital ratios
(1)
Tier 1 capital at least 4% of risk-weighted assets
(2)
Total capital (Tier 1 + Tier 2) at least 8% of risk-weighted assets
2.
Basel II (2004): more sophisticated modeling of credit, market, and operational
risks.
3.
Regulatory sanctions for undercapitalization are severe
Managing Credit Risk.
A.
Managing credit risk of individual lending relationships.
1.
Identifying and monitoring problem loans.
a.
Changes in payment patterns or credit ratings.
b.
Noncompliance or slow compliance with loan covenants.
2.
Loan workouts: restructuring debts for troubled borrowers.
a.
Emphasis shifts from earnings to recovery.
b.
Typically a specialized area within the lending function.
B.
Managing credit risk at portfolio level.
1.
Uses of internal credit risk ratings:
a.
Systematic identification and monitoring of problem loans.
b.
Systematic loan loss reserve allocations.
c.
Risk-based loan pricing
2.
C.
VII.
Loan portfolio analysis: concentration and diversification by—
a.
Industry
b
Geographic region
c.
Collateral
d.
Purpose
Credit Derivatives.
1.
Example: The “Credit Swap”
a.
Seller of swap essentially guarantees payment of some loan or
portfolio of loans
b.
Bank holding loan(s) makes periodic payments to seller of swap
c.
Contracts price according to credit risk
2.
Advantages:
a.
Credit risk is reduced or at least deconcentrated.
b.
Relationship with borrower remains intact.
Measuring and Managing Interest Rate Risk
A.
B.
Measuring Interest Rate Risk: Maturity GAP Analysis
1.
An asset or a liability with an interest rate subject to change within a year is
considered “rate-sensitive”.
2.
RSL
Maturity GAP: Rate-sensitive assets less rate-sensitive liabilities; GAP=RSAa.
Positive GAP: RSA > RSL; bank expects rates to rise
(1)
If interest rates fall-i.
More assets than liabilities will reprice downward,
ii.
thus reducing net interest income.
(2)
If interest rates rise—
i.
More assets than liabilities will reprice upward,
ii.
thus increasing net interest income
b.
Negative GAP = RSA < RSL; bank expects rates to fall
(1)
If interest rates fall—
i.
More liabilities than assets will reprice downward,
ii.
thus increasing net interest income
(2)
If interest rates rise—
i.
More liabilities than assets will reprice upward,
ii.
thus reducing net interest income
c.
Zero GAP: Net interest income unaffected by interest rate fluctuations.
d.
The wider the GAP, the greater the effect of interest rate changes on net
interest income.
Managing Interest Rate Risk: Duration GAP Analysis
1.
Maturity GAP provides only an approximate rule for analyzing interest rate risk.
2.
To reduce reinvestment risk, banks try to match the durations of their assets
and liabilities, not their maturities.
a.
Duration (Chapter 5) is a measure of the average time it takes a security
(or portfolio) to return its present value.
b.
c.
Duration can also be viewed as the effective time until an asset reprices.
Duration GAP analysis matches cash flows and their repricing
capabilities.
3.
The change in the value of a portfolio for a given change in interest rates is
proportional to portfolio’s duration multiplied by the change in interest rates.
4.
Duration GAP: DG = DA – [(MVL/MVA)(DL)]
Where DA
= Portfolio duration of assets
MVL = Market value of Liabilities
MVA = Market value of Assets
DL
= Portfolio duration of liabilities
risk
a.
Positive Duration GAP: Assets have longer duration than liabilities; bank
expects interest rates to fall.
(1)
If interest rates rise—
i.
More assets than liabilities will lose value,
ii.
Thus reducing the value of the bank’s equity.
(2)
If interest rates falli.
More assets than liabilities will gain value,
ii.
Thus increasing the value of the bank’s equity.
b.
Negative Duration GAP: Liabilities have longer duration than assets;
bank expects interest rates to rise.
(1)
If interest rates rise—
i.
More liabilities than assets will lose value,
ii.
Thus increasing the value of the bank’s equity.
(2)
If interest rates falli.
More liabilities than assets will gain value,
ii.
Thus reducing the value of the bank’s equity.
c.
Zero duration GAP: Bank is immunized against interest rate risk.
d.
Duration GAPs are opposite in sign from maturity GAPs for the same
exposure.
C.
Value at Risk (VAR) Analysis. Using historical data, bank estimates mean and
σ of changes in underlying risk factors (e.g. interest rates) affecting asset values. Asset
duration is used to estimate potential change in value for maximum probable change in
risk factor. VAR summarizes the potential for bad outcomes in a single number:
where: ∆V/∆r = sensitivity of changes in asset value to changes in risk factor
∆r*
= potential adverse change in
risk factor within relevant time period for given confidence
level
D.
Hedging Interest Rate Risk: reducing or removing the impact, positive or negative, of
interest rate fluctuations.
1.
“Microhedging” involves a specific transaction (e.g. matched funding).
2.
“Macrohedging” involves the entire balance sheet.
3.
Techniques For Hedging Interest Rate Risk.
a.
Asset-sensitive institutions with positive maturity GAP; negative
duration GAP; hurt by decreasing interest rates:
(1)
Buy financial futures--falling rates would increase value of
contract, offsetting negative impact of GAP
(2)
Buy call options on financial futures
(3)
Swap to increase their variable-rate cash outflows and increase
their fixed-rate (long-term) cash inflows
(4)
Lengthen repricing of assets; shorten repricing of liabilities
b.
Liability-sensitive institutions with negative maturity GAP; positive
duration GAP; hurt by increasing interest rates
(1)
Sell financial futures--increasing rates would increase value of
contract, offsetting negative impact of GAP
(2)
Buy put options on financial futures
(3)
Swap long-term, fixed-rate payments for variable-rate payments
(4)
Shorten repricing of assets; lengthen repricing of liabilities
COMPLETION QUESTIONS
1.
Bank managers must balance a trade-off between __________ and ____________.
2.
The loan loss reserve is a “_______” account deducted from gross loans.
3.
For purposes of liquidity management, vault cash is an example of ______ reserves.
4.
If RSA < RSL the maturity GAP is _________ and net interest income will _________ if interest
rates rise.
5.
Undivided profits are part of _________ capital.
6.
Banks purchase financial futures to hedge against effects of a _____ in interest rates.
7.
______ management theory assumes funds can be readily obtained in the money market by
offering more than the market rate.
8.
Matched-funding is _____ -hedging. Buying futures to hedge a whole balance sheet is _____ hedging.
9.
A positive maturity GAP implies a ________ duration GAP.
10.
Total capital must be at least 8% of ________________ assets.
TRUE/FALSE QUESTIONS
T
F
1.
A high positive GAP is more risky than a high negative GAP.
T
F
2.
“Primary reserves” and “required reserves” are essentially the same thing.
T
F
3.
Excess reserves may be used to meet liquidity needs.
T
F
4.
Bank capital is a cash reserve to pay depositors in case of failure.
T
T
F
F
5.
6.
“Tier 1” capital is more permanent than “Tier 2” capital.
Banks need liquidity for both deposit withdrawals and loan demand.
T
F
7.
A bank with a positive duration GAP expects interest rates to fall.
T
F
8.
Primary reserves maximize liquidity but also earn income.
T
F
9.
Liability management has superseded asset management in managing liquidity.
T
F
10.
A bank with a negative maturity GAP expects interest rates to rise.
MULTIPLE-CHOICE QUESTIONS
1.
Bank capital standards are expressed in terms of percentages of
a.
assets.
b.
deposits.
c.
risk-weighted assets.
d.
industry averages.
2.
The major source of bank revenue is from
a.
loans.
b.
investments.
c.
service charges.
d.
“off-balance-sheet” activities.
3.
The major noninterest expense for banks is
a.
occupancy expense.
b.
income taxes.
c.
salaries and wages.
d.
provision for loan losses.
4.
A bank profit ratio measuring the performance of total assets is called
a.
margin.
b.
ROAE.
c.
capital/asset ratio.
d.
ROAA.
5.
Balancing profitability and safety for banks is more difficult than for other businesses because
a.
banks have low capital/asset ratios.
b.
banks make very risky loans.
c.
most bank liabilities are short term.
d.
both a and c.
6.
A bank can fail either of two ways:
a.
too much GAP or too little GAP.
b.
insufficient leverage or insufficient market share.
c.
insufficient risk or insufficient return.
d.
illiquidity or insolvency.
7.
The major sources of bank liquidity are _____ and _____; the major uses are _____ and _____.
a.
loans and deposits; borrowed funds and selling assets
b.
c.
d.
borrowed funds and loans; deposits and selling assets
selling assets and borrowed funds; loans and deposit withdrawal
borrowed funds and loans; securities and deposit withdrawal
8.
The important characteristics of secondary reserves are
a.
low cost and immediate availability.
b.
excellent liquidity while earning some interest.
c.
nonearning asset with immediate liquidity.
d.
high income with low risk.
9.
Liability management assumes
a.
asset management has been utilized to the fullest extent possible.
b.
the bank is adequately capitalized.
c.
the bank can finance in money markets any time.
d.
primary and secondary reserves are sufficient for any liquidity needs.
10.
Maturity GAP is defined as
a.
rate sensitive assets divided by rate sensitive liabilities.
b.
fixed rate assets minus rate sensitive liabilities.
c.
rate sensitive liabilities plus rate sensitive assets.
d.
rate sensitive assets minus rate sensitive liabilities.
SOLUTIONS TO COMPLETION QUESTIONS
1.
safety; profitability
2.
contra
3.
primary
4.
negative; decrease
5.
“Tier 1” or “core”
6.
decrease
7.
liability
8.
micro; macro
9.
negative
10.
risk-weighted
SOLUTIONS TO TRUE-FALSE QUESTIONS
1.
F
A large GAP in either direction subjects the bank to significant interest rate risk.
T
F
Primary reserves are a financial classification of assets for liquidity management
purposes; required reserves are a regulatory classification. There is significant overlap
between them in terms of the assets qualifying, but they are not the same thing.
By definition, excess reserves are among the most liquid bank assets.
2.
3.
F
Bank capital is an ultimate “cushion” but not an immediate cash reserve. Bank
capital is a set of credit balances on the right side of the balance sheet, not an asset.
4.
5.
T
“Tier 2” capital will not ultimately absorb losses for the going concern.
6.
T
A bank has to supply liquidity on both sides of the balance sheet.
7.
T
A drop in interest rates would increase the value of both assets and liabilities, but
if the duration of assets were greater than that of liabilities, the value of assets would
increase more than that of liabilities and the value of the bank’s equity would increase.
8.
F
Primary reserves (cash and deposits in banks) are almost always nonearning assets.
9.
large
F
Most banks still rely on asset management; liability management is more feasible for
banks with access to the money markets.
10.
F
As interest rates rise, more RSLs reprice upward than RSAs. Net interest income falls.
SOLUTIONS TO MULTIPLE-CHOICE QUESTIONS
1.
c
Capital standards are in terms of percentages of risk-weighted assets.
2.
a
Loans are the major source of revenue.
3.
c
Salaries and wages are the major operating expense of banks.
4.
d
The return on average assets (ROAA) tells how well management uses assets.
5.
d
Lower equity and deposit variability mean that banks must be liquid and safe but
still provide income.
6.
d
A bank can fail from either illiquidity or insolvency.
7.
c
Liquidity may be observed from a sources/uses perspective.
8.
b
Secondary reserves are liquid, earning assets such as Treasury bills.
9.
10.
c
Liability management assumes the market will always lend to the bank if the
bank pays the market price or more.
d
GAP = RSA - RSL