Principles of Bank Management

-Principles of Banking-

Outline
The financial statements of a bank Principles of bank management Measuring and evaluating bank performance Managing bank sources of funds

Part I: The bank firm and bank performance

Introduction to:
Bank balance sheet Process of asset transformation Bank income statement

Measuring and evaluating bank performance

Banks objectives ROE ROA

Banks main business

Accept deposits from customers:
Offer different types of deposit products:
Savings, demand, time, etc Cash ISAs (tax-free)

Make Loans to customers:

Overdrafts (payable on demand) Fixed term loans (incl. Mortgages)

These transformations create various risks: liquidity risk, credit risk, interest rate risk

Banks balance sheet

Total Assets (Uses of funds) Loans and overdrafts Deposits with other banks Items in collection Notes and coins Treasury bills and other securities Reserves Other assets (premises and equipment) Total Liabilities and Equity (Sources of funds) Demand deposits Savings deposits Time deposits Borrowings Other Bank Capital Shareholders capital Loan loss reserves

Balance sheet of all commercial banks (items as a percentage of the total, Jan 2012)
Assets (Uses of funds) Reserves and cash items Securities U.S. government and agency State and local government and other securities Loans Commercial and Industrial Real estate Consumer Interbank Other Other assets (e.g. physical capital) Total Liabilities (Sources of funds) Checkable deposits Non-transaction deposits Small-denomination time deposits Larger-denomination time deposits Borrowings Bank Capital

Total

Assets (Bank uses of funds)

Cash in the vault and deposits held at other depository institutions (C) Government and private interest-bearing securities purchased in the open market (S) Loans and lease financing made available to customers (L) Miscellaneous assets (MA)

The cash account

Cash held in the banks vault Correspondent deposits (placed with other banks) Cash items in the process of collection (mainly uncollected checks) The banks reserve account held with the central bank in the region (primary reserves)

Investment securities
The liquid portion (secondary reserves)
Short-term government securities (government and municipal) Privately issued money market securities
Interest-bearing time deposits Commercial paper

The income generating portion:

Bonds, notes and other securities Trading account securities

Loans
The largest asset item Gross loans: sum of all outstanding IOUs owned to the bank Allowance for possible loan losses (ALL)

Other assets Customers liability on acceptances Miscellaneous assets

Net value of bank buildings and equipment Prepaid insurance Other relatively insignificant asset items

Liabilities and equity capital (sources of funds)

Deposits (D)
non interest-bearing demand deposits (checking accounts) Savings deposits NOW accounts Money market deposit accounts (MMDAs) Time deposits (mainly CDs)

Non-deposit borrowings of funds (NDB)

Short-term borrowings Long-term borrowings

Equity capital (EC)

Capital surplus Retained earnings Contingency reserve

Banks balance sheet

C + S + L + MA = D + NDB + EC Accumulated uses of bank funds (Assets) = Accumulated sources of bank funds (Liabilities and Equity Capital)

Off-balance sheet activities

Standby credit agreements (L/C) Interest rate SWAPS Futures and Options Loan commitments Foreign exchange rate contracts

Income Statement
Financial inflows Loan income Security income Income from cash assets Miscellaneous income Total operating income Financial outflows Deposit costs Non-deposit borrowing costs Salaries and wages expense Miscellaneous expenses Tax expense Total operating expense

Operating profit before provisions = total operating income total operating expenses Provisions for loan losses, contingent liabilities and commitments Operating profit = Operating profit before provisions- provisions Operating profit after tax = Operating profit- tax on profit Operating profit after tax between dividends and retained earnings

Income statement
Bank revenue items Loans (L) Securities (S) Interest-bearing deposits (C) Miscellaneous assets (M) Bank expense items Interest paid out to depositors (D) Interest owed on non-deposit borrowings (NDB) The cost of equity capital (EC) Salaries, wages, benefits paid to bank employees (SWB) Overhead expenses (O) Funds set aside for PLL (PLL) Taxes owed (T) Miscellaneous expenses (ME)

Income instatement
Net income = Total revenue items total expense items Net income = (Crcash + Srsec + Lrloans + MrM) (Did + NDBindb + ECiec + SWB + O + PLL + ME + T)

Exercise
Fill in the missing items from its statement shown below
First banks Balance sheet ($ million) Assets Cash and deposits due from banks Investment securities Trading account securities Federal funds sold Loan, gross Allowance for loan loss Unearned discount on loans Loans, net Bank premises and equipment Customers liability on acceptances Miscellaneous assets Total Assets Income statement Interest and fees on loans Interest on investment securities Other interest income Total interest income Total interest expense Net interest income Provision for loan losses ? 7 5 $180 $159 ? 4 Service charges on customer deposits Trust department income Other operating income Total noninterest income Wages, Salaries, and employee benefits Net occupancy and equipment expense Other expenses Total noninterest expenses Net noninterest income 2 ? ? 8 20 39 ? 7 5 54 ? ? 87 6 11 ? (19) (6) 348 10 18 43 $550 Liabilities Non interest-bearing demand deposits Savings deposits and NOW accounts Money market deposit accounts Time deposits Deposits at foreign branches Total Deposits Non deposit borrowings Other liabilities Stockholders equity capital Total liabilities and equity capital $107 ? 49 227 ? 21 440 41 19 ? $550

Provision for income taxes Net income (or loss) after taxes

Asset Transformation
Banks issue liabilities with certain liquidity, risk and return characteristics
E.g. most bank deposits are redeemable on demand, have low risk and pay the holder a given deposit rate

The bank uses the proceeds to acquire loans with a different set of characteristics Example
Bank raises 100k of onemonth notice time deposits and makes a 25year mortgage loan (maturity transformation: banks borrow short and lend long)

Basic Banking Cash deposit

First National Bank Assets Liabilities First National Bank Assets +100 Liabilities Checkable deposits +100 Vault Cash +100 Checkable Reserves deposit +100

First National Bank Assets Reserves +100 Liabilities

Second National Bank Assets -100 Liabilities Checkable deposits -100

Checkable Reserves deposit +100

Basic Banking Making a Profit

First National Bank Assets Liabilities Required Reserves Checkable +10 deposits +100 Excess Reserves +90 First National Bank Assets Required Reserves Loans +90 Liabilities Checkable +10 deposits +100

Basic Banking--Required Reserves

Deposit of $100 cash into First National Bank assume Required Reserve ratio of 10%

First Nati onal Bank

Assets Required reserves Excess reserves +$10 +$90 Checkable deposits Liabilities +$100

$10 of the deposit must remain in reserves to meet federal regulations (10% reserve req.). Now, the bank is free to work with the $90 in its asset transformation function. In this case, the bank loans the $90 to its customers.

Basic Banking
Loaning out excess reserves

First National Bank

Assets Required reserves Loans +$10 +$90 Checkable deposits Liabilities +$100

Bank Management Aims

A banks objective is to maximise profit while remaining safe and sound:
Must manage assets and liabilities in order to achieve maximum profit

Asset management aims at:

Earning highest possible return from assets at a minimal level of risk:
risk of individual assets (e.g. loans) minimised well diversified portfolio of assets

Utilises methods such as credit risk and interest rate risk management

Liability management aims at:

Acquiring funds at lowest cost

Bank Management Aims

Liquidity management
Banks must be able to meet deposit outflows Involves predicting daily withdrawals and keeping sufficient cash to meet them

Capital adequacy management

bank must be able to sustain some loan losses in order to remain solvent meet regulators demands (Basle Accord stipulates a ratio of 8% of bank capital to assets)

Offbalance sheet (OBS) management

Bank must control and limit exposures from offbalance sheet transactions (e.g. derivative instruments) OBS generate contingent liabilities, in extreme circumstances may result in a bank failing (e.g. Barings Bank)

Principles of Bank Management

Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million Assets Reserves Loans Securities $20 million Deposits $80 million Bank Capital $10 million
Deposit outow

Liabilities $100 million $10 million

- 10 m
Deposit outflow of $10 million
Assets Reserves Loans Securities $10 million Deposits $80 million Bank Capital $10 million Liabilities

- 10 m

$90 million $10 million

With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Liquidity Management
No excess reserves
Assets Reserves Loans $10 million Deposits $90 million Bank Capital Liabilities $100 million $10 million

Securities - 10 m
$10 million

- 10 m

Liabilities

Deposit outflow of $10 million

Assets Reserves Loans Securities $0 million Deposits $90 million Bank Capital $10 million $90 million $10 million

With 10% reserve requirement, bank has $9 million reserve shortfall

Liquidity Management
1. Borrow from other banks or corporations
Assets Reserves Loans Securities
+9m $9

Liabilities

million Deposits

$90 million Borrowings $10 million Bank Capital

$90 million $9 million $10 million

+9m

2. Sell securities
Assets Reserves Loans Securities
+9m

Liabilities $90 million Bank Capital $90 million $10 million

$9 million Deposits

- 9m

$1 million

Liquidity Management
3. Borrow from Fed
Assets Reserves Loans Securities
+9m

Liabilities Deposits $90 million Discount Loans $10 million Bank Capital

$9 million

$90 million $9 million $10 million

+9m

4. Call in or sell off loans

Assets Reserves Loans Securities
+ 9 m $9 -

Liabilities

million Deposits 9 m
$81 million Bank Capital $10 million

$90 million $10 million

Excess reserves are insurance against above 4 costs from deposit outflows

Asset Management
A banks asset portfolio can be thought of as an ordinary portfolio of assets with different riskreturn characteristics
Applying modern portfolio theory suggests deriving an efficient portfolio frontier in the riskreturn space (diversification to eliminate idiosyncratic risk)

Choosing among efficient portfolios according to attitude towards risk However, risk of individual assets is unknown because of imperfect information credit risk analysis

Credit Risk
Basel Committee on Banking Supervision defines credit risk as:
the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. More simply, it is the risk that a loan is not repaid (in part or in full)

Banks face credit risk not only for loans but also for OBS instruments like derivatives, where it is known as counterparty risk.

Credit risk management

Adverse selection and moral hazard are endemic in credit markets. To address them banks engage in:
Screening loan applicants Monitoring and restrictive covenants Specialisation in lending Longterm customer relationships Collateral and compensating balances Credit rationing

Liability Management
Liability Management: managing the source of funds, from deposits, to CDs, to other debt.
Importance has grown dramatically No longer primarily depend on deposits When loan opportunities exist, borrow or issue CDs to acquire funds

Quiz
Define Bank Capital Explain the advantages and disadvantages of maintaining a large amount of bank capital.

Capital Adequacy Management

Bank capital is a cushion that prevents bank failure Consider these two banks:
High Capital Bank
Assets Reserves Loans Liabilities $10 million Deposits $90 million Bank Capital $90 million $10 million

Low Capital Bank

Assets Reserves Loans Liabilities $10 million Deposits $90 million Bank Capital $96 million $4 million

Capital Adequacy Management

What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let s assume both banks lose $5 million from bad loans.

Capital Adequacy Management

Impact of $5 million loan loss
High Capital Bank
Assets Reserves Loans Liabilities $10 million Deposits $85 million Bank Capital $90 million $5 million

Low Capital Bank

Assets Reserves Loans Liabilities $10 million Deposits $85 million Bank Capital $96 million -$1 million

A bank maintains capital to lessen the chance that it will become insolvent.

Capital Adequacy Management

Why don t banks hold want to hold a lot of capital? Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital , EM , ROE

Capital Adequacy Management

Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital requirements
The Basel Committee on Banking Supervision sets minimum capital requirements the ratio of bank capital to risk weighted assets

An under-capitalised capital bank faces loan default

Assets (m) Reserves Cash at Vault Deposits with CB Loans 50 10 40 740 Liabilities (m) Deposits 70

Bank capital 40 Loan loss reserves 20 Shareholders 20 capital Borrowings from other banks 50

Securities Treasury Bills Other bonds

0 0 0

Interest rate risk

First National Bank Assets Rate-sensitive assets Short-term securities Fixed-rate assets Reserves Long-term loans Long-term securities Variable rate and short-term loans Liabilities ($m) 200M Rate-sensitive liabilities Variable-rate CDs Money market deposit accounts 800M Fixed-rate liabilities Checkable deposits Savings deposits Long-term CDs Equity capital 500M 500M

If the bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits

How do banks manage interest rate risk

Gap analysis
Subtract the amount of interest rate-sensitive liabilities form the amount of interest rate-sensitive assets Multiply the gap by the change in interest rate
Obtain the effect on profit

Maturity bucket approach

Basic gap analysis useful for illustrative purposes In reality, assets and liabilities have different maturities Carry out gap analysis at each maturity

Measuring Interest rate risk in practice

Maturity Assets Liabilities Incremental Cumulative (m) (m) GAP (m) GAP (m) INTEREST RATE RISK (annualised) +5% 0-7 days 7-90 days 3-12months 1-2 years 2-5 years 5+ years Total 10 20 50 120 300 500 1000 15 260 385 200 60 80 1000 -5 -240 -335 -80 240 420 -5 -245 -580 -660 -420 0 -0.25 -12.25 -29.00 -33.00 -21.00 0.00 -5% +0.25 +12.25 +29.00 +33.00 +21.00 0.00

How is interest rate risk reduced?

Reduce or eliminate gaps (matching)
Maturity Assets Liabilities Incremental Cumulative (m) (m) GAP (m) GAP (m) INTEREST RATE RISK (annualised) +5% 0-7 days 7-90 days 3-12months 1-2 years 2-5 years 5+ years Total 10 20 50 120 300 500 1000 15 260 385 200 60 80 1000 -5 -240 -335 -80 240 420 -5 -245 -580 -660 -420 0 -0.25 -12.25 -29.00 -33.00 -21.00 0.00 -5% +0.25 +12.25 +29.00 +33.00 +21.00 0.00

Managing Interest rate risk: Matching

Maturity Assets Liabilities Incremental Cumulative (m) (m) GAP (m) GAP (m) INTEREST RATE RISK (annualised) +5% 0-7 days 7-90 days 3-12months 1-2 years 2-5 years 5+ years Total 10 20 250 120 100 500 1000 15 260 385 200 60 80 1000 -5 -240 -135 -80 40 420 -5 -245 -380 -460 -420 0 -0.25 -12.25 -19.00 -23.00 -21.00 0.00 -5% +0.25 +12.25 +19.00 +23.00 +21.00 0.00

Using derivatives to manage Interest rate risk

Matching assets and liabilities has disadvantages:
It is a costly way of managing interest rate risk Prevents banks from issuing fixed interest rate loans, which are attractive to customers

Interest rate swaps offer a better alternative:

Can convert fixed rate assets into rate sensitive assets at relatively low transaction costs Consider the hypothetical balance sheet:
Assume it corresponds to Bank A Assume there is a Bank B that has 200m variablerate loans it wants to convert to 5year fixedrate loans.

An Interest rate SWAP

Bank A has 200m of 5-year fixed rate loans, which it wants to swap for 200m of variable rate loans Bank B has 200m of variable rate loans, which it wants to swap with 5-year fixed rate loans An intermediary matches Bank A and Bank B, for a fee The Banks enter a contract to exchange interest payments on a notional principal of 200m swap interest payments
Fixed rate over 5 year period At 7% p.a. 200m

Bank A
Variable rate (bank rate + 1%) 200m for 5 years

Bank B

Reducing interest rate risk with a SWAP

Maturity Assets Liabilities Incremental Cumulative (m) (m) GAP (m) GAP (m) INTEREST RATE RISK (annualised) +5% 0-7 days 7-90 days 3-12months 1-2 years 2-5 years 5+ years Total 10 220 50 120 100 500 1000 15 260 385 200 60 80 1000 -5 -40 -335 -80 40 420 -5 -45 -380 -460 -420 0 -0.25 -2.25 -19.00 -23.00 -21.00 0.00 -5% +0.25 +2.25 +19.00 +23.00 +21.00 0.00

Market risk and VaR

VaR attempts to answer the following question:
How much money could the bank lose from its portfolio of securities over the next week/month/year with a given probability VaR is a useful summary measure for both bank managers and regulators Its usefulness depends on the accuracy of calculations.

Operational risk
Basle Committee defines operational risk as:
the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

It is very hard to quantify as it captures a whole range of internal and external factors such as: failure of computer systems, rogue traders or genuine human error

Measuring and evaluating bank performance

Banks long-term objective: maximizing the value of the firm Value of the banks stock = Expected stream of future stockholder dividends/Discount factor If the dividends a bank pays its stockholders are expected to grow at a constant rate g over time: P0 = D1/(r-g)

Profitability ratios
Return on Equity capital (ROE) = Net income after taxes/ Total equity capital (1) Return on Assets (ROA) = Net income after taxes/ Total assets (2) Net interest margin = (Interest income from loans and security investments Interest expense on deposits and on the other debt issued)/Total assets (3) Net noninterest margin = (Noninterest revenues Noninterest expenses)/ Total assets (4) Net bank operating margin = (Total operating revenues Total operating expenses)/Total assets (5) Earnings per share (EPS) = Net income after taxes/Common equity shares outstanding (6) Earnings spread = Total interest income/Total earning assets Total interest expense/Total interest-bearing bank liabilities (7)

Closer analysis
ROE = ROA Total assets/Total equity capital (8) ROE = [(Total revenues total operating expenses taxes)/ Total assets] Total assets/Total equity capital ROE = (Net income after taxes/Total Operating revenue) (Total operating revenue/Total assets) (Total assets/Total equity capital) ROE = Net profit margin (NPM) Asset utilization ratio (AU) Equity multiplier (EM) (9)

Measuring risk
Credit risk Liquidity risk Market risk Interest rate risk Earning risk Solvency risk

Credit risk
Nonperforming assets/Total loans and leases Net charge-offs of loans/Total loans and leases The annual provision for loan losses/Total loans and leases (or equity capital) Allowance for loan losses/Total loans and leases (or equity capital) Total loans/ total deposits

Liquidity risk
Purchases funds (Eurodollars, federal funds, security RPs, large CDs, commercial paper/ Total assets Net loans/ Total assets Cash and due-from deposit balance held at other banks/ Total assets Cash assets and government securities/ Total assets

Market risk
A banks book-value assets/ Estimated market value Book-value equity capital/ market value of a banks equity capital The market value of a banks bonds and other fixedincome assets/ Value as recorded on the banks books The market value of a banks common and preferred stock per share

Interest rate risk

Interest sensitive assets/Interest sensitive liabilities Uninsured deposits/Total deposits

Solvency (default) risk

The interest rate spread between market yields on bank debt issues and the market yields on government securities of the same maturity Banks stock price/EPS Equity capital (net worth)/Total assets Purchased funds/Total liabilities Equity capital/Risk assets (loans and securities and exclude cash, plant and equipment, and miscellaneous assets)

Other forms of risk

Inflation risk Currency or exchange rate risk Crime risk Political risk