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Chapter 19 Bank Management Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1 Chapter Outline Bank management Managing liquidity Managing interest rate risk Managing credit risk Managing market risk Operating risk Managing risk of international operations Bank capital management Management based on forecasts Bank restructuring to manage risks Integrated bank management 2 Bank Management The goal behind managerial policies of a bank is to maximize the wealth of the bank’s shareholders Managers may be tempted to make decisions that are in their own best interests Banks can incur agency costs Banks could provide stock as compensation to managers to maximize the bank’s stock price Banks with a low stock price may become takeover targets 3 Bank Management (cont’d) Board of directors The board of directors oversees operations of the banks and attempts to ensure that managerial decisions are in the best interests of shareholders Bank boards tend to contain a higher percentage of outside members than boards of other types of firms Functions of bank directors are to: Determine a compensation system for bank executives Ensure proper disclosure of the financial condition and performance Oversee growth strategies such as acquisitions Oversee policies for changing capital structure Assess performance and ensure that corrective action is taken if there is weak performance 4 Managing Liquidity Banks can experience illiquidity when cash outflows exceed cash inflows Banks should maintain the level of liquid assets that will satisfy their liquidity needs but use their remaining funds to satisfy their other objectives Illiquidity can be resolved by creating additional liabilities or selling assets Research has shown that high-performance banks are able to maintain relatively low liquidity Use of securitization to boost liquidity Securitization commonly involves the sale of assets by the bank to a trustee who issues securities that are collateralized by the assets Securitization converts future cash flows into immediate cash 5 Managing Interest Rate Risk Bank performance is influenced by the interest payments earned relative to the interest paid: Net interest margin Interest revenues - Interest expenses Assets 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 (see next slide) During a period of decreasing interest rates, a bank’s net interest margin will likely increase if its liabilities are more rate sensitive than its assets (see next slide) 6 Managing Interest Rate Risk (cont’d) Increasing Interest Rates Decreasing Interest Rates % % Rate on Loans Rate on Loans Spread Cost of Funds Cost of Funds Time Time 7 Managing Interest Rate Risk (cont’d) To measure interest rate risk, a bank measures the risk and then uses its assessment of future interest rates to decide whether and how to hedge the risk Methods used to assess interest rate risk: Gap analysis Duration analysis Regression analysis 8 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Gap analysis Gap is defined as: Gap Rate sensitive assets - Rate sensitive liabilitie s The gap ratio is the volume of rate-sensitive assets divided by rate-sensitive liabilities 9 Computing A Bank’s Gap and Gap Ratio Philly Bank generated interest revenues of $100 million last year and $45 million in interest expenses. Philly bank has $2 billion in assets, of which $800 million are rate-sensitive. Philly also has $700 million in rate-sensitive liabilities. What are Philly Bank’s gap and gap ratio? Gap Rate sensitive assets - Rate sensitive liabilitie s $800,000,000 $700,000,000 $100,000,000 $800,000,0 00 Gap ratio 114.29% $700,000,000 10 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Gap analysis (cont’d) Banks often classify assets and liabilities into categories based on the time of repricing and calculate a gap for each category Banks must decide how to classify their liabilities and assets as rate sensitive versus rate insensitive Each bank may have its own classification system, because there is no perfect measurement of gap 11 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Duration measurement Duration can capture the different degrees of interest rate sensitivity: n Ct ( t ) t t 1 (1 k ) DUR n Ct t ( 1 k ) t 1 The duration of a bank’s asset portfolio is the weighted average of the durations of the individual assets 12 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Duration measurement (cont’d) The bank can also estimate the duration of its liability portfolio and then estimate the duration gap: DURGAP DURAS - DURLIAB LIAB/AS A duration gap of zero means the bank is not exposed to interest rate risk Banks with positive duration gaps are adversely affected by rising interest rates and positively affected by declining interest rates 13 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Duration measurement (cont’d) Assets with shorter maturities have shorter durations Assets that generate more frequent coupon payments have shorter durations The capabilities of duration are limited when applied to assets that can be terminated on a moment’s notice 14 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Regression analysis A bank can assess interest rate risk by determining how performance has historically been influenced by interest rate movements A proxy must be chosen for bank performance and for prevailing interest rates and regression analysis can be applied: R B0 B1Rm B2 i u 15 Managing Interest Rate Risk (cont’d) Methods used to assess interest rate risk (cont’d) Regression analysis (cont’d) A positive (negative) coefficient suggests that performance is favorably (adversely) affected by rising interest rates If the interest rate coefficient is zero, the bank’s stock returns are insulated from interest rate movements The vast majority of research has found that bank stock levels are inversely related to interest rate movements Regression analysis can be combined with the value-at-risk (VAR) method to determine how its market value would change in response to specific interest rate movements 16 Managing Interest Rate Risk (cont’d) Determining whether to hedge interest rate risk Banks should consider using their measurement of interest rate risk along with their forecast of interest rate movements to determine whether they should hedge Since none of the measures is perfect for all situations, some banks measure interest rate risk using all three methods In general, the three methods should lead to a similar conclusion (see next slide) 17 Gap Analysis If the bank’s gap is: …and interest rates are expected to: …the bank should: Increase Consider hedging Decrease Remain unhedged Increase Remain unhedged Decrease Consider hedging Negative Positive 18 Duration Gap Analysis If the bank’s duration gap is: …and interest rates are expected to: …the bank should: Increase Remain unhedged Decrease Consider hedging Increase Consider hedging Decrease Remain unhedged Negative Positive 19 Regression Analysis If the bank’s Interest rate coefficient is: …and interest rates are expected to: …the bank should: Increase Consider hedging Decrease Remain unhedged Increase Remain unhedged Decrease Consider hedging Negative Positive 20 Managing Interest Rate Risk (cont’d) Methods used to reduce interest rate risk Maturity matching The bank can match each deposit’s maturity with an asset of the same maturity Very difficult to implement because deposits are short term Using floating-rate loans Floating-rate loans allow banks to support long-term assets with short-term deposits If the cost of funds is changing more frequently than the rate on assets, there is still interest rate risk Could result in increased exposure to credit risk 21 Managing Interest Rate Risk (cont’d) Methods used to reduce interest rate risk (cont’d) Using interest rate futures contracts The sale of a futures contract on Treasury bonds prior to an increase in interest rates will result in a gain The size of the bank’s position in Treasury bond futures is dependent on the size of its asset portfolio, the degree of its exposure to interest rate movements, and its forecast of future interest rate movements 22 Managing Interest Rate Risk (cont’d) Methods used to reduce interest rate risk (cont’d) Using interest rate swaps A bank whose liabilities are more rate sensitive than its asset 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 rates rise, the bank benefits because the payments to be received from the swap will increase while its outflow payments are fixed A bank whose assets are more rate sensitive than its liabilities can swap variable-rate payments in exchange for fixed-rate payments 23 Managing Interest Rate Risk (cont’d) Methods used to reduce interest rate risk (cont’d) Using interest rate caps An agreement to receive payments when the interest rate of a particular security or index rises above a specified level during a specified time period can be used to hedge interest rate risk During periods of rising interest rates, the cap provides compensation which can offset the reduction in spread 24 Managing Interest Rate Risk (cont’d) International interest rate risk With foreign currency balances, the strategy of matching asset and liability interest rate sensitivity will not automatically achieve a low degree of interest rate risk 25 Managing Credit Risk Most of a bank’s funds are used either to make loans or to purchase debt securities, which expose the bank to credit risk Tradeoff between credit risk and expected return Because a bank cannot simultaneously maximize return and minimize credit risk, it must compromise It will select some assets that generate high returns but are subject to a high degree of credit risk It will select some assets that are very safe but offer a lower rate of return The bank attempts to earn a reasonable return and maintain credit risk at a tolerable level 26 Managing Credit Risk (cont’d) Tradeoff between credit risk and expected return (cont’d) How the loan allocation decision affects return and risk Credit cards and consumer loans offer the highest margins above the bank’s cost of funds Credit cards and consumer loans will experience more defaults than other types of loans Many banks have adopted more lenient credit standards to generate credit card business For banks that were too lenient, the wide spread between the return on credit card loans and the cost of funds has been offset by a high level of bad debt expenses 27 Managing Credit Risk (cont’d) Tradeoff between credit risk and expected return (cont’d) Changes in expected return and risk Banks adjust their asset portfolio according to changes in economic conditions Banks generally reduce loans and increase purchases of low-risk securities when the economy is weak When economy conditions began to improve in 2003, banks were more willing to provide more loans subject to more risk 28 Managing Credit Risk (cont’d) Measuring credit risk Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness Determining the collateral The bank must decide whether to require collateral than can back the loan Determining the loan rate Ratings are used to determine the premium to be added to the base rate according to credit risk Some loans to high-quality customers are commonly offered at rates below the prime rate 29 Managing Credit Risk (cont’d) Diversifying credit risk Banks should diversify their loans to make sure their customers are not dependent on a common source of income Applying portfolio theory to loan portfolios The variance of an asset portfolio’s return is: n n w i w j COV(Ri , R j ) 2 p i 1 j 1 The covariance measures the degree to which asset returns move in tandem 30 Managing Credit Risk (cont’d) Diversifying credit risk (cont’d) The covariance is equal to the correlation coefficient between asset returns times the standard deviation of each asset’s return, so: n n w i w j ij i j 2 p i 1 j 1 The portfolio variance is positively related to the correlations between asset returns If a bank’s loans are driven by one particular economic factor, the returns will be highly correlated 31 Managing Credit Risk (cont’d) Diversifying credit risk (cont’d) Industry diversification of loans If one particular industry experiences weakness, loans to other industries will be insulated Diversifying loans across industries has limited effectiveness when economic conditions are weak Geographic diversification of loans Diversification of loans across districts could achieve significant risk reduction in loan portfolios because of low correlations 32 Managing Credit Risk (cont’d) Diversifying credit risk (cont’d) International diversification of loans Diversification of loans across countries can reduce exposure to any one country Banks should assess a country’s risk and focus on countries with a high country risk rating The international debt crisis in the 1980s and the Asian Crisis of 1997 dampened the desire by banks to diversify loans internationally 33 Managing Credit Risk (cont’d) Diversifying credit risk (cont’d) Selling loans Banks can eliminate loans that are causing excessive risk in their portfolios by selling them in the secondary market Loan sales often enable the bank originating the loan to continue servicing the loan Revising the loan portfolio in response to economic conditions When economic conditions deteriorate, a bank’s loan portfolio may be heavily exposed to economic conditions even if it has purchased additional Treasury securities 34 Managing Market Risk Market risk results from changes in the value of securities due to changes in financial market conditions such as interest rate movements, exchange rate movements, and equity prices As banks pursue new services related to the trading of securities, their exposure to market risk has increased Banks face increased market risk because of their increased involvement in the trading of derivatives 35 Managing Market Risk (cont’d) Measuring market risk Banks commonly use value-at-risk to measure their exposure to market risk Involves determining the largest possible loss that would occur as a result of changes in market prices based on a specified confidence level The bank estimates the impact of an adverse scenario on its positions based on the sensitivity of the values of its positions to the scenario Using the VAR method, the bank can ensure that it has sufficient capital to cushion against the adverse effects of the scenarios 36 Managing Market Risk (cont’d) Measuring market risk (cont’d) Bank Banks continually revise their estimate of market risk in response to changes in their investment and credit positions and to changes in market conditions How revisions of market risk measurements J.P. Morgan assesses market risk Uses a 95 percent confidence level to determine the maximum expected one-day loss on its investments and credit instruments due to changes in interest rates, foreign exchange rates, equity prices, and commodity prices 37 Managing Market Risk (cont’d) Measuring market risk (cont’d) Relationship between a bank’s market risk and interest rate risk A bank’s market risk is partially dependent on its exposure to interest rate risk Banks give special attention to interest rate risk because it is the most important component of market risk Methods used to reduce market risk A bank could reduce its involvement in the activities that cause the high exposure e.g., reduce the amount of transactions in which it serves as a guarantor for its clients or reduce its investment in foreign debt securities 38 Operating Risk Operating risk is the risk resulting from a bank’s general business operations related to: Information Execution of transactions Damaged relationships with clients Legal issues Regulatory issues 39 Managing Risk of International Operations Exchange rate risk Some international loans contain a clause that allows repayment in a foreign currency, allowing the borrower to avoid exchange rate risk Often, banks convert available funds to whatever currency corporations want to borrow Creates an asset denominated in a foreign currency and a liability denominated in a different currency The bank’s profit margin is reduced if the liability currency appreciates against the asset currency Banks typically hedge net exposure to exchange rate risk 40 Managing Risk of International Operations (cont’d) Settlement risk: Is the risk of loss due to settling bank transactions e.g., a bank may send its currency to another bank, but that bank may not send anything back Can create systemic risk, which is the risk that many participants will be unable to meet their obligations because they did not receive payments on obligations due to them 41 Bank Capital Management Bank operations are different from other types of firms because the majority of their assets generate more predictable cash flows Banks can use a much higher degree of leverage than other types of firms Banks must meet the minimum capital ratio required by regulators If a bank has too much capital, each shareholder will receive a smaller proportion of any distributed earnings 42 Bank Capital Management (cont’d) A common measure of the return to shareholders is return on equity (ROE): ROE Net profit after taxes Equity Return on assets (ROA) Leverage measure Net profit after taxes Assets Assets Equity The greater the leverage measure, the greater the amount of assets per dollar of equity 43 Computing Banks’ ROEs Hidebt Bank and Lodebt Bank each have an ROA of 2 percent. Hidebt Bank has a leverage measure of 13, while Lodebt Bank has a leverage measure of 9. What is the ROE for each bank? ROE for Hidebt Return on assets (ROA) Leverage measure 2% 13 26% ROE for Lodebt Return on assets (ROA) Leverage measure 2% 9 18% 44 Bank Capital Management (cont’d) Banks can reduce the required level of capital by selling some loans in the secondary market Banks’ required capital is specified as a proportion of loans Banks can reduce excessive capital by distributing a high percentage of their earnings to shareholders Capital management is related to dividend policy 45 Management Based on Forecasts Adjustment to Asset Structure Assessment of Bank’s Adjusted Structure Strong economy Concentrate more heavily on loans; reduce holdings of low-risk securities Increased potential for stronger earnings; increased exposure of bank earnings to credit risk Weak economy Concentrate more heavily on risk-free low-risk loans; reduce holdings of risky loans Reduced credit risk; reduced potential for stronger earnings if the economy does not weaken Economic Forecast Adjustment to Liability Structure Increasing interest rates Attempt to attract CDs with long-term maturities Apply floating interest rates to loans whenever possible; avoid long-term securities Reduced interest rate risk; reduced potential for stronger earnings if interest rates decrease Decreasing interest rates Attempt to attract CDs with short-term maturities Apply fixed interest rates to loans whenever possible; concentrate on long-term securities or loans Increased potential for stronger earnings; increased interest rate risk 46 Bank Restructuring to Manage Risks Bank operations change in response to changing regulations and economic conditions and to managerial policies designed to hedge risk Decisions to restructure are complex because of their effects on customers, shareholders, and employees A strategic plan to satisfy customers and shareholders may not satisfy employees e.g., many banks downsized in the early 1990s 47 Bank Restructuring to Manage Risks (cont’d) Bank acquisitions Banks can restructure by growing through acquisitions of other banks Acquisitions offer advantages: Economies of scale Diversification of loans Acquisitions have disadvantages: Optimistic projections of cost efficiencies Employee morale problems and high employee turnover 48 Integrated Bank Management Bank management of assets, liabilities, and capital is integrated Asset growth can be achieved only if a bank obtains the necessary funds Growth may require an investment in fixed assets that will require an accumulation of bank capital An integrated management approach is necessary to manage liquidity risk, interest rate risk, and credit risk 49