chapter 13.ppt

Chapter 13: Bank Management

Financial Markets and Institutions Chapter 13

Chapter ObjectivesDescribe the underlying goal of bank managementExplain how banks manage liquidityExplain how banks manage interest rate riskExplain how banks manage credit riskExplain how banks manage capital


Goal of Bank ManagementThe bank manager has four primary concernsTo keep enough cash on hand liquidity managementTo pursue low level of risk asset managementTo acquire funds at low cost liability managementTo maintain the amount of capital capital adequacy management


Goal of Bank ManagementThe underlying goal of bank management is to maximize the wealth of the banks shareholdersMaximizing the share priceAgency costsManagers not acting in shareholders best interestsTakeover target


Risks Faced By BanksValue ofBankValueRelated toCash FlowsandRisk ofCash Flows


Managing LiquidityBanks experience illiquidity when cash outflows exceed cash inflowsBanks can resolve cash deficiencies by either creating additional liabilities or selling assetsBorrowing: fed funds, discount windowSome assets are more liquid than othersBalancing liquidity vs. maintaining a reasonable return


Managing LiquidityUse of securitization to boost liquiditySelling off loans to trusteeMortgage and automobile loansTrustee issues securities collateralized by the assetsLoan payments pass through to holders of securitiesSecuritization turns future cash flows into immediate cash


Managing Interest Rate RiskBank performance is sensitive to interest received on loans relative to interest paid on depositsDifference = net interest marginNet interest margin = Interest revenues Interest expensesAssets


Managing Interest Rate RiskDetermining whether to hedge interest rate riskBanks often use all three methodsBanks use their analysis of gap with interest rate forecasts to make their hedging decisionMethods of reducing interest rate riskMaturity matchingUsing floating-rate loansUsing interest rate futures contractsUsing interest rate swapsUsing interest rate caps


Managing Interest Rate RiskMethods of reducing interest rate riskMaturity matchingMatch each deposits maturity with an asset of the same maturityDifficult to implementLots of short term depositsUsing floating rate loansOften increases credit risk and liquidity risk


Managing Interest Rate RiskMethods of reducing interest rate riskUsing interest rate futures contractsE.g. sale of T-bond futures prior to interest rate rise results in a gain, offsetting other adverse effectsUsing interest rate swapsArrangement to exchange periodic cash flows based on specific interest ratesFixed-for-floatingUsing interest rate caps


Managing Credit RiskMost of a banks funds are used to make loans or purchase securitiesIn either case, the bank is subject to credit (or default) riskTradeoff between credit risk and expected returnInvesting in Treasuries minimizes credit risk but also generates a small returnConsumer and small-business loans have a high return but generate a lot of riskCant simultaneously maximize return and minimize riskChanges in expected return and risk


Managing Credit RiskMeasuring credit riskRequires a credit assessment of loan applicantsCredit analystsEvaluation indicates the probability of the firm being able to repay the loanDetermining the collateralIn the event the borrower is unable to repayDetermining the loan rateHigher risk requires higher rates


Managing Credit RiskDiversifying credit riskEnsures that borrowers are not all dependent on common source of incomeApplying portfolio theory to loan portfoliosCovariance and correlationIf a banks loans are not driven by a common economic factor then risk will be reducedIndustry diversification of loansInsulates the bank from a downturn in a single industryGeographic diversification of loansAdjacent areas tend to be more highly correlated in terms of production levels


Managing Credit RiskDiversifying credit riskInternational diversification of loansMay not help if the bank accepts loans from areas with very high credit riskSelling loansProblem loans can be removed from the banks assetsRevising the loan portfolio in response to economic conditionsIn bad economic conditions, businesses are less able to repay...


Managing Market RiskMarket risk results from the changes in value of securities due to changes in financial market conditions such as interest rates, exchange rates, and equity pricesBanks have increased exposure to derivatives and trading activitiesMeasuring market riskBanks commonly use value-at-risk (VAR), which involves determining the largest possible loss that would occur in the event of an adverse scenario


Managing Market RiskMeasuring market riskBank revisions of market risk measurementsWhen changes in market conditions occur, such as increasing volatility, banks revise their estimates of market riskHow J.P. Morgan assesses market riskCalculates a 95 percent confidence interval for the expected maximum one-day loss due to:Interest rates, exchange rates, equity prices, commodity prices, and correlations between these variables


Managing Market RiskMethods of reducing market riskReduce involvement in activities that cause high exposureTake offsetting trading positionsSell securities that are heavily exposed to market risk


Operating RiskOperating risk results from a banks general business operationsProcessing and sorting informationExecuting transactionsMaintaining relationships with clientsDealing with regulatory issuesLegal issues


1. Market RiskRisk a rising from adverse movements in the level or volatility of market prices.2. Credit Risk The risk that a counterparty will fail to perform on an obligation.3. Liquidity Risk The risk that you may not be able to or cannot easily unwind or offset a particular position at or near the previous market price because of inadequate market depth or because of disruptions in the market. 4. Settlement Risk The risk that a firm will not receive funds or instruments from its counterparties at the expected time. 5. Operational Risk The risk that deficiencies in information systems or internal controls will result in unexpected loss. This risk is associated with human error, system failures and inadequate procedures and controls. 6. Legal Risk The risk that contracts are not legally enforceable or documented correctly.


Management Based on ForecastsSome banks position themselves to benefit form expected changes in the economyIf managers expect a strong economy they may shift toward riskier loans and securitiesInaccurate forecasts have less effect on more conservative banks


Bank Restructuring to Manage RisksDecisions are complex because they affect customers, employees, and shareholdersBank acquisitionsCommon form of restructuringQuick way of achieving growthAdvantages:Economies of scale, diversificationManagerial advantagesDisadvantagesPurchase price may be too highEmployee morale


Bank Restructuring to Manage RisksAre bank acquisitions worthwhileStudies show that the market reacts neutrally or negatively to news of a bank acquisitionMay be due to:Pessimism over whether efficiencies will be achievedPersonnel clashesPrice may be too high


Integrated Bank ManagementBank management of assets, liabilities, and capital is necessarily integratedAn integrated management approach is also necessary to manage liquidity risk, interest rate risk, and credit risk


chapter 13.ppt

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