Download Assets

Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Fifth Canadian Edition
Chapter 13
BANKING AND
THE MANAGEMENT OF FINANCIAL
INSTITUTIONS
Copyright © 2014 Pearson Canada Inc.
Learning Objectives
1. Outline a bank’s sources and uses of funds
2. Specify how banks make profits by accepting deposits
and making loans
3. Discuss how bank managers manage credit risk and
interest-rate risk
4. Explain gap analysis and duration analysis
5. Illustrate how off-balance-sheet activities affect bank
profits
Copyright © 2014 Pearson Canada Inc.
13-2
Assets
•
•
•
•
•
•
Reserves
Cash Items in Process of Collection
Deposits at Other Banks
Securities
Loans
Other Assets
Copyright © 2014 Pearson Canada Inc.
13-3
Liabilities
• Demand and Notice Deposits
• Fixed-Term Deposits
• Borrowings
– overdraft loans (advances)
– settlement balances
• Bank Capital
Copyright © 2014 Pearson Canada Inc.
13-4
Balance Sheet of All Banks in Canada
Copyright © 2014 Pearson Canada Inc.
13-5
Basic Banking
• First Bank makes a loan of $100 to a business and
credits the business's chequable deposit
First Bank
Assets
Loans
+$100
Business
Liabilities
Chequable
deposits
+$100
Assets
Chequable
Deposits
+$100
Liabilities
Bank Loans
+$100
• Opening of a chequing account leads to an increase in
the bank’s reserves equal to the increase in chequable
deposits
Copyright © 2014 Pearson Canada Inc.
13-6
Basic Banking (cont’d)
• When a bank receives additional deposits, it gains an
equal amount of reserves: when it loses deposits, it
loses an equal amount of reserves
First Bank
Assets
Cash items in
process of
collection
Liabilities
+$100
Chequable
deposits
+$100
First Bank
Assets
Reserves
+$100
Second Bank
Liabilities
Chequable
deposits
Copyright © 2014 Pearson Canada Inc.
+$100
Assets
Reserves
Liabilities
-$100
Chequable
deposits
-$100
13-7
Basic Banking: Making a Profit
First Bank
Assets
Desired
reserves
Excess
reserves
First Bank
Liabilities
+$100 Chequable
deposits
+$90
+$100
Assets
Liabilities
Desired
reserves
+$10 Chequable
deposits
Loans
+$90
+$100
• Asset transformation-selling liabilities with one set of
characteristics and using the proceeds to buy assets with a
different set of characteristics
• The bank borrows short and lends long
Copyright © 2014 Pearson Canada Inc.
13-8
General Principles of Bank Management
•
•
•
•
•
•
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
Copyright © 2014 Pearson Canada Inc.
13-9
Liquidity Management: Ample Reserves
with deposit outflow of $10
million
↓
First Bank
Assets
First Bank
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
Capital
$10M
Securities
Assets
$100M
$10M
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank Capital
$10M
Securities
$10M
• If a bank has ample excess reserves, a deposit outflow does not
necessitate changes in other parts of its balance sheet
Copyright © 2014 Pearson Canada Inc.
13-10
Liquidity Management: Shortfall in Reserves
with deposit outflow of $10
million
↓
First Bank
Assets
First Bank
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Securities
$100M
$10M
Assets
Reserves
Loans
Securities
Liabilities
$0 Deposits
$90M Bank
Capital
$10M
$90M
$10M
• Reserves are a legal requirement and the shortfall must be
eliminated
• Excess reserves are insurance against the costs associated with
deposit outflows
Copyright © 2014 Pearson Canada Inc.
13-11
Liquidity Management: Borrowing from other
Banks
First Bank
Assets
Reserves
Liabilities
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
$10M
• Cost incurred is the interest rate paid on the borrowed funds
Copyright © 2014 Pearson Canada Inc.
13-12
Liquidity Management: Securities Sale
First Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M Deposits
$90M
$90M Borrowing
$0M
$1M Bank Capital
$10M
• The cost of selling securities is the brokerage and other
transaction costs
Copyright © 2014 Pearson Canada Inc.
13-13
Liquidity Management: Bank of Canada Advances
First Bank
Assets
Reserves
Loans
Securities
Liabilities
$9M Deposits
$90M Advances Bank of
Canada
$1M Bank Capital
$90M
$9M
$10M
• Borrowing from the Bank of Canada also incurs interest
payments based on the discount rate
Copyright © 2014 Pearson Canada Inc.
13-14
Liquidity Management: Reduce Loans
First Bank
Assets
Reserves
Liabilities
$9M Deposits
Loans
$81M Advances Bank of
Canada
Securities
$10M Bank Capital
$90M
$0M
$10M
• Reduction of loans is the most costly way of acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a substantial
discount
Copyright © 2014 Pearson Canada Inc.
13-15
Asset Management: Three Goals
1. Seek the highest possible returns on loans and
securities
2. Reduce risk
3. Have adequate liquidity
Copyright © 2014 Pearson Canada Inc.
13-16
Asset Management: Four Tools
• Find borrowers who will pay high interest rates and
have low possibility of defaulting
• Purchase securities with high returns and low risk
• Lower risk by diversifying
• Balance need for liquidity against increased returns
from less liquid assets
Copyright © 2014 Pearson Canada Inc.
13-17
Liability Management
• Recent phenomenon due to rise of money center banks
• Expansion of overnight loan markets and new financial
instruments (such as negotiable CDs)
• Checkable deposits have decreased in importance as
source of bank funds
Copyright © 2014 Pearson Canada Inc.
13-18
Capital Adequacy Management
• Bank capital helps prevent bank failure
• The amount of capital affects return for the owners
(equity holders) of the bank
• Regulatory requirement
Copyright © 2014 Pearson Canada Inc.
13-19
Capital Adequacy Management: Preventing
Bank Failure
High Bank Capital
Assets
Low Bank Capital
Liabilities
Assets
Liabilities
Reserves
$10M Deposits
$90M Reserves
$10M Deposits
Loans
$90M Bank Capital
$10M Loans
$90M Bank Capital
High Bank Capital
Assets
$10M Deposits
Loans
$85M Bank Capital
Copyright © 2014 Pearson Canada Inc.
$4M
Low Bank Capital
Liabilities
Reserves
$96M
Assets
$90M Reserves
$5M Loans
Liabilities
$10M Deposits
$96M
$85M Bank Capital
-$1M
13-20
Capital Adequacy Management: Returns to
Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity capital
ROA =
net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
ROE =
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
Equity Capital
net profit after taxes net profit after taxes
assets
=
´
equity capital
assets
equity capital
EM =
ROE = ROA ´ EM
Copyright © 2014 Pearson Canada Inc.
13-21
Capital Adequacy Management: Safety
• Benefits the owners of a bank by making their
investment safe
• Costly to owners of a bank because the higher the bank
capital, the lower the return on equity
• Choice depends on the state of the economy and levels
of confidence
Copyright © 2014 Pearson Canada Inc.
13-22
Strategies for Managing Bank Capital
Lowering Bank Capital:
• Buying back some of Bank’s stock
• Pay out higher dividend to shareholders
• Acquire new funds and increase assets
Raising Bank Capital:
• Issue more common stock
• Reducing dividend to shareholders
• Issue fewer loans or sell securities and use proceeds
to reduce liabilities
Copyright © 2014 Pearson Canada Inc.
13-23
Application: How a Capital Crunch Caused a
Credit Crunch During the Global Financial Crisis
• Shortfalls of bank capital led to slower credit growth
– Huge losses for banks from their holdings of securities
backed by residential mortgages
– Losses reduced bank capital
• Banks could not raise much capital on a weak
economy, and had to tighten their lending standards
and reduce lending
Copyright © 2014 Pearson Canada Inc.
13-24
Managing Credit Risk
• A major component of many financial institutions
business is making loans
• To make profits, these firms must make successful
loans that are paid back in full
• The concepts of moral hazard and adverse selection
are useful in explaining the risks faced when making
loans
Copyright © 2014 Pearson Canada Inc.
13-25
Managing Credit Risk: Adverse Selection
• Adverse selection is a problem in loan markets because
bad credit risks (those likely to default) are the one
which usually line up for loans
• Those who are most likely to produce an adverse
outcome are the most likely to be selected
Copyright © 2014 Pearson Canada Inc.
13-26
Managing Credit Risk: Moral Hazard
• Moral hazard is a problem in loan markets because
borrowers may have incentives to engage in activities
that are undesirable from the lenders point of view
• Once a borrower has obtained a loan, they are more
likely invest in high-risk investment projects that might
bring high rates of return if successful
• The high risk, however, makes it less likely the loan will
be repaid
Copyright © 2014 Pearson Canada Inc.
13-27
Managing Credit Risk (cont’d)
• To be profitable, lending firms must overcome adverse
selection and moral hazard problems
• Attempts by the lending institutions to solve the
problems explains a number of principles for managing
risk
Copyright © 2014 Pearson Canada Inc.
13-28
Managing Credit Risk (cont’d)
• Screening and Monitoring
– Screening
– Specialization in Lending
– Monitoring and Enforcement of Restrictive Covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
Copyright © 2014 Pearson Canada Inc.
13-29
Interest Rate Risk
• If a financial institution has more interest rate sensitive
liabilities than interest rate sensitive assets, a rise in
interest rates will reduce the net interest margin and
income
• If a financial institution has more interest rate sensitive
assets than interest rate sensitive liabilities, a rise in
interest rates will raise the net interest margin and
income
Copyright © 2014 Pearson Canada Inc.
13-30
Managing Interest-Rate Risk
First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
$50M
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
Equity capital
Copyright © 2014 Pearson Canada Inc.
13-31
Gap Analysis
• The Gap is the difference between interest rate
sensitive liabilities and interest rate sensitive assets
GAP = rate-sensitive assets – rate-sensitive liabilities
GAP = RSL – RSA
• A change in the interest rate (Δi) will change bank
income (I) depending on the Gap
Income = GAP  i
Copyright © 2014 Pearson Canada Inc.
13-32
Duration Analysis (cont’d)
• Owners and managers care not only about the change
in interest rates on income but also on net worth of the
institution
• Duration Analysis examines the sensitivity of the
market value of the financial institution’s net worth to
changes in interest rates
Copyright © 2014 Pearson Canada Inc.
13-33
Duration Analysis (cont’d)
%ΔP = - DUR x [Δi/(1+i)]
Where:
P is the market value
%ΔP = (Pt+1 – Pt)/P
DUR = duration
i = interest rate
Copyright © 2014 Pearson Canada Inc.
13-34
Duration Analysis (cont’d)
The Duration Gap can be calculated as:
DURgap = Dura – (L/A x DURL)
Where:
Dura = average duration of assets
L = market value of liabilities
A = market value of assets
Durl = average duration of liabilities
Copyright © 2014 Pearson Canada Inc.
13-35
Off-Balance-Sheet Activities
• Loan sales (secondary loan participation)
• Generation of fee income
• Trading activities and risk management techniques
– Futures, options, interest-rate swaps, foreign exchange
– Speculation
Copyright © 2014 Pearson Canada Inc.
13-36
Off-Balance-Sheet Activities (cont’d)
• Trading activities and risk management techniques
– Financial futures, options for debt instruments, interest rate
swaps, transactions in the foreign exchange market and
speculation
– Principal-agent problem arises
Copyright © 2014 Pearson Canada Inc.
13-37
Off-Balance-Sheet Activities (cont’d)
• Internal controls to reduce the principal-agent problem
– Separation of trading activities and bookkeeping
– Limits on exposure
– Value-at-risk
– Stress testing
Copyright © 2014 Pearson Canada Inc.
13-38