Chapter 10

Banking and
the Management
of Financial
Institutions
 The Bank Balance Sheet

• Liabilities (sources of funds)

– Checkable deposits
– Non-transaction deposits (savings accounts,
time deposits, certificate deposits)
– Borrowings (from Central Bank, other banks,
corporations)
– Bank capital (net worth, raised by selling new
equity or from retained earnings, cushion
against drop in asset value)

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 The Bank Balance Sheet (cont’d)

• Assets (uses of funds)

– Reserves (at the CB, plus vault cash; comprises
required and excess returns )
– Cash items in process of collection (e.g., checks
coming in)
– Deposits at other banks
– Securities (mainly government securities, viewed
as secondary reserves)
– Loans
– Other assets (e.g., physical capital)

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 Table 1 Balance Sheet of All
Commercial Banks (items as a
percentage of the total, June 2011

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 Basic Banking: Cash Deposit

First National Bank First National Bank

Assets Liabilities Assets Liabilities

Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100

Cash deposits deposits

• Opening of a checking account leads to an increase

in the bank’s reserves equal to the increase in
checkable deposits

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 Basic Banking: Check Deposit

First National Bank

Assets Liabilities
Cash items in +$100 Checkable +$100
process of deposits
collection

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits

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 Basic Banking: Making a Profit

First National Bank First National Bank

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

• 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

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 General Principles of Bank
Management

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk

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 Liquidity Management: Ample
Excess Reserves

Assets Liabilities Assets Liabilities

Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M

• Suppose bank’s required reserves are 10%

• If a bank has ample excess reserves, a deposit
outflow does not necessitate changes in other parts
of its balance sheet

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 Liquidity Management: Shortfall
in Reserves

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M

• Reserves are a legal requirement and the shortfall must

be eliminated
• Excess reserves are insurance against the costs
associated with deposit outflows
• The higher the costs associated with deposit outflows,
the more excess reserves banks will want to hold
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 Liquidity Management: Borrowing

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

• Cost incurred is the interest rate paid on the

borrowed funds (the interbank rate)

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 Liquidity Management: Federal
Reserve

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M

• Borrowing from the Fed also incurs interest

payments based on the discount rate

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 Liquidity Management: Securities
Sale

Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M

• The cost of selling securities is the brokerage and

other transaction costs

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 Liquidity Management: Reduce
Loans

Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $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
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 Asset Management: Three Goals

• 1. Seek the highest possible returns on loans

and securities
• 2. Reduce risk
• 3. Have adequate liquidity

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 Asset Management: Four Tools

• 1. Find borrowers who will pay high

interest rates and have low possibility
of defaulting
• 2. Purchase securities with high returns and
low risk
• 3. Lower risk by diversifying
• 4. Balance need for liquidity against
increased returns from less liquid assets

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 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

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 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

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 Capital Adequacy Management:
Preventing Bank Failure

High Bank Capital Low Bank Capital

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

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M

Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

A bank maintains bank capital to lessen the chance that it will

become insolvent
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 Capital Adequacy Management:
Returns to Equity Holders

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 Capital Adequacy Management

• High Capital Bank

– EM = $100M/$10M = 10
– If ROA = 1%, the ROE = 1% x 10 = 10%
– Profit per unit of asset is 10%
• Low Capital Bank
– EM = $100M/$4M = 25
– If ROA = 1%, then ROE = 1% x 25 = 25%
• Given the return on assets, the lower the
bank capital, the higher the return for the
owners of the bank!

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 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
• Trade-off between safely and returns to
equity holders
• Choice depends on the state of the economy
and levels of confidence
• Banks also hold capital because they were
required by regulators to do so
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 Strategies for Managing Bank
Capital
• Case 1: If as bank manager you feel that a large
amount of bank capital is causing the return on
equity to be too low, and you conclude that the
bank has a capital surplus and should increase the
equity multiplier to raise ROE. What should/ can
you do to raise EM (=assets/equity capital)
– Reduce the amount of bank capital by buying back some of
the bank’s stock
– Reduce the amount of bank capital by paying out higher
dividends to stock holders (i.e., decresing retained
earnings)
– Increase the bank’s assets (in turn increase liabilities)

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 Strategies for Managing Bank
Capital
• Case 2: If as bank manager you feel that your bank
is short on capital relative to assets, hence without
a sufficient cushion against bank failure. What
should/can you do to raise the amount of capital
relative to assets (i.e., lower EM)?
– Raise the amount of bank capital by having the bank issue
common stock
– Raise the amount of bank capital by reducing dividends to
stock holders (i.e., increasing retained earnings)
– Reduce the bank’s assets by making fewer loans and
selling off securities (in turn, reducing liabilities)
• A shortfall of bank capital is likely to lead to a bank
reducing its assets and therefore a contracting in
lending.
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 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.

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 Managing Credit Risk

• Screening and Monitoring

– Screening
– Specialization in lending
– Monitoring and enforcement of
restrictive covenants

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 Managing Credit Risk (cont’d)

• Long-term customer relationships

• Loan commitments
• Collateral and compensating balances
• Credit rationing

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 Managing Interest-Rate Risk

First National Bank

Assets Liabilities
Rate-sensitive assets $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 $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital

• If a 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

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 Gap and Duration Analysis

• Basic gap analysis:

(rate sensitive assets - rate sensitive liabilities) x interest rates = in bank
profit
• Maturity bucked approach
– Measures the gap for several maturity
subintervals called maturity bucket so that
effects of interest rate changes over a multiyear
period can be calculated.
• Standardized gap analysis
– Accounts for different degrees of rate sensitivity
for different rate-sensitive A & L.

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 Gap and Duration Analysis
(cont’d)

Duration analysis
- Based on Macaulay’s concept of duration, which measures the
average lifetime of a security’s stream of payments
- Examines the sensitivity of the market value of the bank’s total A
& L to changes in interest rates

% in market value of security  - percentage point in interest

rate x duration in years.
• Uses the weighted average duration of a financial
institution’s assets and of its liabilities to see how
net worth responds to a change in interest rates.

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 Strategies for Managing
Interest Rate Risk
• Suppose as bank manager you have done a
duration and gap analysis of your bank,
which has greater rate-sensitive liabilities
than assets. You now need to decide which
alternative strategies to pursue to manage
interest-rate risk.
– If you believe interest rates will fall, what should
you do?
– Suppose you realize the bank is subject to
substantial interest-rate risk, meaning there’s
always that possibility that rates will rise. What
should you do to eliminate the interest rate risk?
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 Strategies for Managing
Interest Rate Risk
– To eliminate interest-rate risk, adjust the banks balance
sheet (their A&L), so that income will be less affected by
interest rate swings. In this case:
• Shorten the duration of the bank’s assets to increase their
rate sensitivity.
• Or, lengthen the duration of liabilities.
– Downside of this:
• Altering the balance sheet may be costly in the short run
(i.e., the bank may be locked in to A&L of particular
durations because of where its expertise lies)
– Financial derivatives can help the bank reduce its
interest-rate risk exposure without requiring the bank to
rearrange the balance sheet.
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 Off-Balance-Sheet Activities

• Loan sales (secondary loan participation)

• Generation of fee income. Examples:
– Servicing mortgage-backed securities (collecting customers’
interest payments and principal and then paying them out)
– Guaranteeing debt securities (e.g., banker’s acceptances
– Providing backup lines of credit (e.g., loan commitments,
credit lines, letters of credit, note issuance facilities,
revolving underwriting facilities)
– Creating SIVs (structured investment vehicles) which can
potentially expose banks to risk, as it happened in the
global financial crisis

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 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.
– While these are meant to reduce risk or facilitate
other bank business, at times encourages
speculation
– Principal-agent problem arises

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 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 (interest rate, inflation, exchange
rate, asset market values… etc.)

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