1

Chapter 9 Banking and Management of Financial Institutions

Because banking system plays a major role in channeling funds from the

savers/lenders to investors/borrowers, it is important to study how the

banking system runs its business to maximize its profit, how and why

banks make loans, how they acquire funds and manage their assets and

liabilities.

THE BANK BALANCE SHEET To understand how banking works we start by looking at the bank balance

sheet.

The bank balance sheet is a list of the bank assets (what bank owns) and

liabilities (what it owes) where,

Total assets = total liabilities + bank’s equity capital (net worth)

Banks make profits by receiving interest rates on their asset holdings of

securities and loans that is higher than the expenses of their liabilities.

Liabilities Liabilities are the sources of bank’s funds. Banks obtain funds by borrowing

and by issuing (selling) other liabilities such as deposits. Liabilities include

o Checkable Deposits

They are bank accounts that allow the owner of the account to write

checks to third parties. Checkable deposits include (1) non-interest

bearing checking account (demand deposits), (2) interest-bearing

accounts (NOW accounts: negotiable order of withdrawal), and (3)

money market deposit accounts (MMDAs).

2

MMDAs are not subject to reserve requirements as checkable

deposits are, and are not included in the M1 definition of money.

Checkable deposits and money market deposit accounts are payable

on demand.

o Non-transaction deposits

They are the main source of bank funds. Owners cannot write

checks on non-transaction deposits, but the interest rates paid on

these deposits are usually higher than those on checkable deposits.

There are two basic types of non-transaction deposits: saving

accounts and time deposits (also called CDs).

Saving accounts, which funds can be added to or withdrawn

from at any time.

Time deposits have a fixed maturity length and charge high

penalties for early withdrawal. They are less liquid than saving

accounts but earn higher interest rate.

o Borrowings

Banks also obtain funds by borrowing from the central bank, other

commercial banks, and corporations.

o Bank Capital Bank capital or net worth is the difference between total assets and

total liabilities. Bank capital is raised by selling new equity (stock) or

retained earnings.

Assets

The funds obtained from issuing liabilities are used to acquire income-

earning assets such as securities and loans.

Banks assets are referred to as uses to which funds are put, and the

interest payments earned on them are what enable banks to make profit.

Asset side of the balance sheet includes

3

o Reserves

Reserves include what banks keep with central bank plus currency

(papers and coins) kept in the bank vaults.

Reserves are held for two reasons:

First, it is required by regulations that banks must keep a

fraction (required reserve ratio) of the money in their checkable

deposits as reserve. This is called required reserves.

Second, banks hold additional reserves, called excess

reserves, to meet obligations when funds are withdrawn,

directly by a depositors or indirectly when a check is written on

an account.

o Cash items in process of collection.

When a check written on an account at another bank is deposited in

your bank and the funds for this check has not been collected from

the other bank, it is an asset for your bank because it is a claim on

another bank for funds that will be paid within a few days.

o Deposits at other banks (corresponding banking) Many small banks hold deposits in larger banks in exchange for a

variety of services, including check collection, foreign exchange

transactions, and help with securities purchase.

o Securities

A bank’s holdings of securities are an important income-earning

asset.

o Loans

Banks make their profits primarily by issuing loans. Because of the

lack of liquidity and higher default risk, the bank earns its highest

return on loans.

4

o Other Assets

The physical capital (bank buildings, computer, and other equipment)

owned by the banks is included in this category.

BASIC BANKING In general terms, banks make profits by selling liabilities with one set of

characteristics (a particular combination of liquidity, risk, size, and return)

and using the proceeds to buy assets with a different set of characteristics.

This process is often referred to as asset transformation.

For example, a saving deposit held by one person can provide the funds

that enable the bank to make a mortgage loan to another person. The bank

has, in effect, transformed the saving deposits (an asset held by the

depositor) to a mortgage loan (an asset held by the bank).

The process of transforming assets and providing a set of services (check

clearing, record keeping, credit analysis, and so forth) is like any other

production process in a firm. If the bank produces desirable services at low

cost and earns reasonable income on its assets, it earns profits; if not, the

bank suffers losses.

To make the analysis of the operation of a bank more concrete, let us use

a tool called T-account.

A T-account is a simplified balance sheet, with lines in the form of a T, that

lists only the changes that occur in balance sheet items starting from some

initial balance sheet position.

For example, if you have just opened a checking account with a $100 bill.

You have a $100 checkable deposit at a bank (the First Bank), which

shows up as a $100 liability on the bank balance sheet. The bank now put

your $100 bill into its vault so that the bank’s assets rise by the $100

increase in vault cash.

5

The T-account for the First Bank looks like this

Assets Liabilities

Vault cash +$100 Checkable deposits +100

Because vault cash is part of reserves, we can rewrite the T-account as

follows

Assets Liabilities

Reserves +$100 Checkable deposits +100

Note that opening a new checking account leads to an increase in the bank's

reserves equals to the increase in checkable deposits.

Alternatively, suppose you had opened the account with a $100 check written

on an account at another bank (the Second Bank), we would get the same

result. The initial effect on the T-account of your bank (the First Bank) is as

follows:

Assets Liabilities Cash items in +$100 Checkable deposits +100

process of collection

To collect the fund of its customer (you) from the Second Bank, the First bank

will deposit the check in its account with the central bank, and the central bank

will collect the funds from the Second Bank.

If the central bank transfers the $100 of reserves from the Second Bank to the

First Bank and the final balance sheet position of the two banks are as follows

First Bank

Assets Liabilities

Reserves $100 checkable deposits $100

6

Second Bank

Assets Liabilities Reserves - $100 checkable deposits - $100

When a bank receives additional deposits, it gains an equal amount of

reserves; when it loses deposits, it loses an equal amount of reserves.

To make a profit, bank rearranges its balance sheet when it experiences a

change in its deposits.

As we know, the bank obliged to keep a certain fraction (required reserves ratio) of its checkable deposits as required reserves. If the required reserves

ratio (RRR) is 10%, the First Bank required reserves have increased by $10

as can be see below.

First Bank

Assets Liabilities Required Reserves + $10 checkable deposits $100 Excess Reserves + $90

To make a profit, the bank must put to productive use all or part of the $90 of

excess reserves it has available.

If the bank decides not to hold any excess reserves but to make loans instead.

The T-account then looks like this

First Bank

Assets Liabilities Required Reserves + $10 checkable deposits $100 Loans + $90

The bank now is making profit because it holds short term liabilities such as

checkable deposits and uses the proceeds to buy longer-term assets such as

loans with higher interest rates.

The above discussion has shown you how a bank operates. Now let us see

how a bank manages its assets and liabilities to earn the highest profit.

7

GENERAL PRINCIPLES OF BANK MANAGEMENT The bank manager has five primary concerns:

1. To make sure that the bank has enough ready cash to pay its depositors

when there are deposit-outflows (because depositors make withdrawals

and demand payment). To keep enough cash on hand, the bank must

engage in liquidity management, which is the acquisition of sufficiently

liquid assets to meet the bank obligations to depositors.

2. To pursue an acceptable low level of risk by acquiring assets which have a

low rate of default (credit risk) and by diversifying asset holdings (asset management).

3. To acquire funds at low cost (liability management). 4. To decide the amount of capital the bank should maintain and then acquire

the needed capital (capital adequacy management). 5. To manage risks associated with financial institution practices such as

interest-rate risk (the risk of earnings and returns on bank assets that

results from interest-rate changes).

LIQUIDITY MANAGEMENT AND THE ROLE OF RESERVES To show how banks deal with deposit outflows that occur when depositors

withdraw cash or write checks that are deposited in other banks let us assume

that the bank has the following initial balance sheet with RRR=10%

First Bank

(numbers are in millions)

Assets Liabilities Reserves $20 Deposits $100 Loans $80 Bank Capital $ 10 Securities $10

From the above information we can see that the bank has ER=$10

If a deposit outflow occurs, the bank’s balance sheet becomes

8

Assets Liabilities Reserves $10 Deposits $90 Loans $80 Bank Capital $10 Securities $10

The bank loses $10 millions of deposits and $10 million of reserves. However,

its RR now is $9 millions and ER = $1 millions.

The conclusion is that if the bank has ER, a deposit outflow does not

necessitate changes in other parts of its balance sheet.

The situation is quite different when a bank does not hold ER

Assets Liabilities Reserves $10 Deposits $100 Loans $90 Bank Capital $ 10 Securities $10

When the bank suffers the $10 million deposit outflows, its balance sheet

becomes

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

After $10 million has been withdrawn from deposits and hence reserves, the

bank has a problem. The RR is $9 million, but the bank has no reserves.

To eliminate this shortfall , the bank has four options

1. To borrow the $9 million from other banks or corporations. The BS

becomes

Assets Liabilities Reserves $ 9 Deposits $90 Loans $90 Borrowing from other Securities $10 banks and corporations $ 9 Bank Capital $10

The cost of this activity is the interest rate on these borrowings.

9

2. To sell some of its securities to help cover the deposit outflow. For

example, it might sell $9 million of its securities and deposit the

proceeds with the central bank, resulting in the following BS

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

The bank incurs some brokerage and other transaction costs

when it sells these securities.

3. To borrow $9 million in discount loans from the central bank. Its BS

now would be

Assets Liabilities Reserves $ 9 Deposits $90 Loans $90 Borrowing from the Securities $10 central bank $ 9 Bank Capital $10 The cost associated with discount loans is the interest rate that

must be paid to the central bank (called the discount rate).

4. To reduce the bank’s loans by $9 million and deposit the amount with

the central bank. This transaction changes the BS as follows

Assets Liabilities Reserves $ 9 Deposits $90 Loans $81 Bank Capital $10 Securities $10

This process is the costliest way of acquiring reserves because if

the bank refuses to renew the loans to some of its customers this

will upset them and may take their businesses away from he

10

bank. And if the bank sells some of the loans off to other banks,

these loans will be sold lower than their full value

The above discussion explains why banks hold ER even though loans or

securities earn a higher return. When a deposit outflow occurs, holding ER

allows the bank to escape the costs of (1) borrowing from other banks or

corporations, (2) selling securities, (3) borrowing from the central bank, or (4)

calling in or selling off loans.

ERs are insurance against the costs associated with deposit outflows. A bank

is willing to pay the cost of holding ER (the opportunity cost, the earnings

forgone by not holding income-earning assets such as loans or securities) to

insure against loses due to deposit outflows.

Because ERs have a cost, banks also take other steps to protect themselves;

for example, they might shift their holdings of assets to more liquid securities

(secondary reserves).

ASSET MANAGEMENT To maximize its profits, a bank must simultaneously (1) seek the highest

returns possible on loans and securities, (2) reduce risk, and (3) make

adequate provisions for liquidity by holding liquid assets. In order for banks to

accomplish these three goals, they follow a strategy of asset management that

can be summarized in the following four basic ways.

1. Banks try to find borrowers who will pay high interest rates and are

unlikely to default. Loans officers engage in screening of the

potential borrowers to reduce the adverse selection process.

2. Banks try to purchase securities with high returns and low risk.

3. Banks must attempt to lower risk by diversifying their assets, and

making different types of loans to different types of customers.

4. Banks must manage the liquidity of its assets so that it can satisfy its

reserves requirements without bearing huge costs. This means that

11

banks will hold securities that are more liquid even if they earn

somewhat lower return than other assets. The bank must balance its

desire for liquidity against the increased earnings that can be

obtained from less liquid assets such as loans.

LIABILITY MANAGEMENT Since checkable deposits are no longer the main source of banks’ funds,

banks no longer treated their sources of funds (liabilities) as given.

Banks aggressively set target goals for their asset growth and tried to acquire

funds by issuing liabilities as they were needed. For example, when a bank

finds an attractive loan opportunity it can acquire funds by selling negotiable

CDs or through borrowing from the central bank fund market.

Because of the increased flexibility and importance of liability management,

most banks now manage both sides of the BS together in an asset-liability

management (ALM) committee.

12

CAPITAL ADEQUACY MANAGEMENT Banks have to make decisions about the amount of capital they need to hold

for three reasons.

1. Bank capital helps prevents bank failure, a situation in which the

bank cannot satisfy its obligations to pay its depositors and other

creditors.

2. The amount of capital affects returns for the owners (equity-holders)

of the bank.

3. A minimum amount of bank capital (bank capital requirements) is

required by regulatory authorities.

How Bank Capital Helps Prevent Bank Failure?

Let us consider two banks with identical balance sheet except that the High

Capital Bank has a ratio of capital to assets of 10% while the Low Capital

Bank has a ratio of 4%.

High Capital Bank

Assets Liabilities Reserves $10 Deposits $90 Loans $90 Bank Capital $10

Low Capital Bank

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

Suppose a $5 million of bad loans to both banks are written off (valued at zero), the total value of assets declines by $5 million. As a consequence, bank

capital, which equals total assets minus liabilities, also declines by $5 million.

The balance sheets of the two banks look like this.

13

High Capital Bank

Assets Liabilities Reserves $10 Deposits $90 Loans $85 Bank Capital $ 05

Low Capital Bank

Assets Liabilities Reserves $10 Deposits $96 Loans $85 Bank Capital - $01

The High Capital Bank still has a positive net worth (bank capital) of $5 million

after the loss. The value of Low Capital Bank’s assets has fallen below its

liabilities and its net worth is now -$1 million. It does not have sufficient assets

to pay off all holders of its liabilities (creditors). So, it is insolvent and

government regulators will close the bank.

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

How the Amount of Bank Capital Affects Returns to Equity Holders?

Because owners of a bank must know whether their bank is being managed

well, they need good measures of bank profitability.

A basic measure of profitability is the return on assets (ROA), the net profit

after taxes per dollar of assets.

assetstaxes after profit netROA =

The return on assets provides information on how efficiently a bank is being

run, because it indicates how much profits are generated on average by each

dollar of assets.

However, what the bank’s owners (equity holders) care about most is how

much the bank is earning on their equity investment. This information is

provided by the other basic measure of bank profitability, the return on equity (ROE), the net profit after taxes per dollar of equity (bank) capital.

14

capital equitytaxes after profit netROE =

There is a direct relationship between the return on assets (which measure

how efficiently the bank is run) and the return on equity (which measure how

well the owners are doing on their investment).

This relationship is determined by the so-called equity multiplier (EM), which

is the amount of assets per dollar of equity capital

capital equityassetsEM =

To see this, we note that:

capital equityassets

assetstaxes after profit net

capital equitytaxes after profit net

×=

Which yields, ROE = ROA x EM

Therefore, given the return on assets, the lower the bank capital the higher the

returns for the owners of the bank.

Bank capital benefits the owners of a bank in that it makes their investment

safer by reducing the likelihood of bankruptcy.

Bank capital is costly because the higher it is the lower will be the return on

equity for a given return on assets.

In determining the amount of bank capital, managers must decide how much

of the increased safety that comes with higher capital they are willing to trade

off against the lower return on equity that comes with higher capital.

In more uncertain times, when the possibility of large losses on loans

increases, bank managers might want to hold more capital to protect the

equity holders. Conversely, if they have confidence that loan losses won’t

occur, they might want to reduce the amount of capital, have a high equity

multiplier, and thereby increase the return on equity.

15

MANAGING CREDIT RISK

Banks and other financial institutions make loans that must be paid back in

full.

The possibility of default subjects the financial institutions to credit risk.

The economic concepts of adverse selection and moral hazard provide a

framework for understanding the principles that financial institutions have to

follow to reduce credit risk and make successful loans.

Adverse selection in loan markets occurs because bad credit risks (the most

likely to default on their loans) are the ones who usually line up for loans. In

other words, those who are most likely to produce an adverse outcome are the

most likely to be selected. Borrowers with very risky investment projects have

much to gain if their projects are successful. However, they are the least

desirable borrowers because of the greater possibility that they will be unable

to pay back their loans.

Moral hazard exists in loan markets because borrowers may have incentives

to engage in activities that are undesirable from the lenders point of view. In

such situations, it is more likely that the lender will be subjected to the hazard

of default.

To be profitable, financial institutions must overcome the adverse selection

and moral hazard problems that make loan defaults more likely.

The attempts of financial institutions to solve these problems help explain a

number of principles for managing credit risk such as (1) screening and

monitoring, (2) establishment of long-term customer relationships, (3) loan

commitments, (4) collateral and compensating balance requirements, and (5)

credit rationing.

(1) Screening and Monitoring Asymmetric information is present in loan markets because lenders have less

information about investment opportunities and activities of borrowers than

16

borrowers do. This situation leads to two information-producing activities by

banks and other financial institutions: screening and monitoring.

Screening

Adverse selection in loan markets requires that lenders screen out the bad

credit risks from the good ones so that loans are profitable to them. To

accomplish effective screening, lenders must collect reliable information from

prospective borrowers.

Effective screening together with information collection form an important

principle of credit risk management.

The lender uses the information collected from the various forms you filled in

to evaluate how good a credit risk you are by calculating your credit score, a

statistical measure derived from your answers that predicts whether you are

likely to have trouble making your loan payments.

Deciding on how good a risk you are cannot be entirely scientific. Personal

judgment of the loan officer that is based on the experience and other factors

is also important.

Specializing in lending

Banks often specialize in lending to local firms or to firms in particular

industries. It looks like the bank is not diversifying its portfolio of loans and

thus exposing itself to more risk. However, the adverse selection problem

requires that the bank screen out bad credit risk. To do the screening

effectively, it is easier for the bank to collect information about local firms and

determine their creditworthiness than doing the same thing for firms far away.

Similarly, by concentrating its lending on firms at specific industries, the bank

becomes more knowledgeable about these industries and is therefore better

able to predict which firms will be able to make timely payments on their debts.

17

Monitoring and Enforcement of Restrictive covenants

Once a loan has been made, the borrower has an incentive to engage in risky

activities that make it less likely that the loan will be paid off.

To reduce this moral hazard, financial institutions (the lenders) should write

provisions (restrictive covenants) into loan contracts that restrict borrowers

from engaging in risky activities.

By monitoring borrowers activities to see whether they are complying with the

restrictive covenants and by enforcing the covenants if they are not, lenders

can make sure the borrowers are not taking on risks at their expense.

The need for banks and other financial institutions to engage in screening and

monitoring explains why they spend so much money on auditing and

information-collecting activities.

(2) Long-Term Customer Relationship Another principle of credit risk management is to establish a long-term

relationship with customers. This allows banks and other financial institutions

to obtain information about their borrowers.

If a prospective borrower has had an account with or loans from a bank over a

long period of time, a loan officer can look at past activity on the accounts and

learn quite a bit about the borrower.

The long-term customer relationships reduce the costs of information

collection and make it easier to screen out bad credit risks.

Long-term customer relationships enable banks to deal with even

unanticipated moral hazard contingencies. The borrower has the incentive to

avoid risky activities that would upset the bank in order to preserve a long-

term relationship with the bank, which will make it easier to get future loans at

low interest rates. This behavior benefits both the bank and the customer.

18

(3) Loan Commitments Banks also create long-term relationships and gather information by issuing

loan commitments to commercial customers.

A loan commitment is a bank’s commitment for a specified future period of

time to provide a firm with loans up to a given amount at an interest rate that is

tied to some market interest rate.

The majority of commercial and industrial loans are made under the loan

commitment arrangement.

The advantage for the firm is that it has a source of credit when it needs it.

The advantage for the bank is that the loan commitment promotes a long-term

relationship, which in turn facilitates information collection.

A loan commitment agreement is a powerful method for reducing the bank’s

costs for screening and information collection.

(4) Collateral and Compensating Balances Collateral requirements for loans are important credit risk management tools.

Collateral is property promised to the lender as compensation if borrower

defaults.

It lessens the consequences of adverse selection because it reduces the

lender’s losses in the case of loan default. If a borrower defaults on a loan, the

lender can sell the collateral and use the proceeds to make up for it losses on

the loan.

One particular form of collateral required when a bank makes commercial

loans is called compensating balances.

Compensating balances means that when a firm receives a loan it must

keep a required minimum amount of funds in a checking account at the bank.

By requiring the borrower to use a checking account at the bank, the bank can

observe the firm’s check payment practices, which may yield a great deal of

information about the borrower’s financial condition.

19

MANAGING INTEREST RATE RISK Interest-rate risk refers to the risk of earnings and returns that is associated

with changes in interest rates.

To see what interest-rate risk is, let’s look at the balance sheet of the First

Bank

Assets Liabilities

Rate-sensitive assets $20 Rate-sensitive liabilities $50 Variable-rate and Variable-rate CDs Short-term loans Money market deposit Short-term securities accounts Fixed-rate assets $80 Fixed-rate liabilities $50 Reserves Checkable deposits Long-term loans Saving deposits Long-term securities Long-term CDs Equity capital

Rate-sensitive: when interest rates change frequently (at least once a year)

Fixed-rate: when interest rates remain unchanged for a long period (over a

year)

Suppose the interest rates rise by 5%.

o The income on assets increase by $1 million (= 5% X $20 million of

rate-sensitive assets)

o Payments on liabilities increase by 2.5 million (= 5% x $50 million of

rate-sensitive liabilities).

o Thus, the profits of the First Bank now decline by $1.5 million ($1m –

$2.5m).

Conversely, if interest rates fall by 5%, the bank’s profits will increase by

$1.5m.

The conclusion is that 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 increase bank profits.

20

Gap and Duration Analysis The sensitivity of bank profits to changes in interest rates can be measured

more directly using gap analysis and /or duration analysis.

Gap Analysis

Gap refers to the difference between the rate-sensitive assets and rate-

sensitive liabilities. The gap in our example is $20m– 50m= -30m

By multiplying the gap times the change in the interest rate we can

immediately obtain the effect on bank profits.

∆ bank profit = Gap x ∆i = ($20 – $50) x 0.05 = -$30m x 0.05 = -$1.5m

Duration Analysis Duration refers to the average lifetime of stream of payments.

Duration Analysis examines the sensitivity of the market value of bank’s total

assets and liabilities to changes in interest rates.

Duration analysis uses the average (weighted) duration of a financial

institution’s assets and liabilities to see how the net worth responds to a

change in interest rates.

%∆ market value of security ≈ -∆i x duration in years

Suppose:

o The average duration of the First Bank’s assets is 3 years (the

average lifetime of stream of payments in 3 years),

o The average duration of its liabilities is 2 years,

o The bank has a$100m of assets and $90m of liabilities, and

o Interest rate increased by 5%

Market value The market value of the bank’s assets falls by 15% (= -5% x 3) or $15m.

The market value of the liabilities falls by 10% (= -5% x 2) or $9m.

Net worth

21

Before = $100 - $90 = $10m

Now = $85 -$81 = $4m

Hence, the net worth has declined by 6% of the total original asset value.

Similarly, a 5% decrease in interest rates increase the net worth of the bank

by 6% of the total asset value.

Both gap analysis and duration analysis indicate that the First Bank will suffer

if interest rates rise but it will gain if they fall.