Chapter 9

The Banking Firm and the Management of

Financial Institutions

g

Dr. Reyadh Faras

Commercial banks are the most important financial intermediaries in the economy, so it is important to understand how they operate, and understand bank management.

THE BANK BALANCE SHEET

To understand how a bank operates, we first examine a commercial bank's balance sheet, where:

Total Assets = Total Liabilities + Capital  

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التجاري ) البنك BalanceميزانيةSheet)اإللتزامات األصول

ودائع ( ثابتة ادخارية، (جارية،

احتياطياتالبنك ) لدى ودائع نقدية،

(المركزي

اقتراضبنوك ) المركزي، البنك من

بنوك قابضة، شركات أخرى، (أجنبية

حكومية دين أدوات ( سندات خزانة، (أذونات

المساهمين حقوقمحتفظ ) أرباح المال، رأس

(بها

عقارية، ( استهالكية، قروض( أخرى بنوك تجارية،

ثابتة أصولأنظمة ) أثاث، مباني،

(إلكترونية

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The Bank Balance Sheet

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BANK LIABILITIES )Sources of Funds, Sources of costs(

1. Checkable Deposits )11%( Are bank accounts that allow owner of the account to

write checks to third parties. They include:

a. Demand deposits )non-interest-bearing checking(

b. Negotiable Order of Withdrawal )NOW( accounts )interest-bearing checking(

c. Money market deposit accounts )MMDAs( - money market mutual funds.

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Checkable deposits are payable on demand, you can write a check for any amount, including your entire balance.

Checkable deposits are lowest cost source of funds for a bank, sometimes zero )demand deposits(.

Because people like the liquidity of checking accounts, they are willing to forego interest for convenience of checks.

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2. Nontransaction Deposits )52%(

Account owner is not allowed to write checks, but

receives interest rates higher than checkable deposits.

a. Savings accounts:

Funds can be added or withdrawn from the account.

b. Time Deposit Accounts: Fixed maturity from several months to 10 years. Higher interest rates than saving accounts. Has penalties for early withdrawal. Less liquid. More costly source of funds for the bank.

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Interest Rates on KD Time Deposits )%(

Amount1

Month2

Months3

Months4

Months6

Months9

Months12

Months

1,500 – 9,999 5.0000 5.0625 5.1875 5.1875 5.3125 5.3750 5.4375

10,000 – 50,000

5.1250 5.1875 5.3125 5.3125 5.4375 5.5000 5.5625

50,001 – 250,000

5.2500 5.3125 5.4375 5.4375 5.5625 5.6250 5.6875

250,001 – 999,999

5.375 5.4375 5.5625 5.5625 5.6875 5.7500 5.8125

Longer Time Deposits

2 Years

3 Years 4 Years 5 Years

5.9375 6.2500 6.5000 6.7500

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3. Borrowings )29%( a. From other banks (interbank Market)

b. From the central bank (discount Window)

c. From parent companies (bank holding companies)

d. From corporations (repurchase agreements)

e. From foreign banks (Eurodollar deposits)

f. Issue debt instruments (Commercial Papers, Bonds)

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4. Bank capital )Net Worth( )8%(

Net worth is the difference between total assets and liabilities.

Consists of stocks and retained earnings.

  Bank capital is a cushion against a drop in the

value of assets, to protect against bankruptcy )insolvency(.

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BANK ASSETS )Uses of Funds, Sources of income(:

Banks use their deposits to acquire income-earning

assets, to make profits, by earning more interest on

assets than they pay out on liabilities.

1. Reserves )1%(: Consists of deposits kept on account at the central

bank  plus cash held at the bank. Some reserves are required by the central bank

and others are voluntary.

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Required Reserves: banks are required to hold a percentage of certain deposits in an account at the central bank.

Excess reserves: in addition to required reserves,

banks hold extra reserves for increased liquidity )to meet demand for cash withdrawals and check clearing(.

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1968 1978 1988

1998

United Kingdom 20.5 15.9 5.0 3.1

Turkey 58.3 62.7 30.8 18.0

Germany 19.0 19.3 17.2 11.9

United States 12.3 10.1 8.5 10.3

The Required Reserve Ratio Over Time (%)

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Country RRR )%(

Note

Australia & Canada None

Euro Zone 2.0 Since 1999

Russia4.0 Effective 1/4/2011,

up from 2.5 in 1/2011

Bangladesh 6.0 Since December 2010

Turkey 8.0Since February 2011

China 21.5For major Chinese banks since 14/6/2011, it was 15.5%. Small/Medium banks: 18.5%

Surinam 25.0 Down from 27%, effective from 1/1/2007

Lebanon 30.0

The Required Reserve Ratio Around the World

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Required and Excess Reserves in the US: 2007- 2009

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2. Cash Items in Process of CollectionFunds from checks written on other banks but are not yet collected )received( from the other bank.

 3. Deposits at Other BanksMany )small( banks hold deposits at other )larger(banks to use them in getting a number of services such as: check collection, foreign exchange transactions, and buying securities.

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4. Securities )22%(:

An important source of income to banks.

Made up entirely of government debt instruments because commercial banks are not allowed to own stocks.

Short term securities are highly liquid, thus are called secondary reserves.

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5. Loans )66%(:

Most bank profits come from Loans. 

A loan is a liability for the borrower but an asset for the bank because it generates income.

Loan Types:

a. Commercial loans to businesses

b. Real estate loans )mortgages, home improvement loans(

c. Consumer loans )Cars, furniture(

d. Interbank loans )overnight loans to other banks through the interbank market(

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Loans are less liquid than other assets because they are tied up for the length of the loan.

Loans are also more risky, have higher default risk than securities.

Because loans are more risky and less liquid, they earn more interest for banks.

6. Other Assets )7%(: Buildings, office equipment, computer systems,

etc.

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Summarized Balance Sheet

Assets Liabilities + Capital

Reserves Deposits

Securities Borrowings

Loans Capital

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BASIC OPERATION OF A BANK

Asset Transformation: Banks make profits by selling liabilities with one

set of characteristics )liquidity, risk, and return( and buying assets with different set of characteristics.

Example:

A savings deposit )liability( can be used by the bank to make a loan )asset(.

The bank borrows short-term and lends long-term.

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Characteristics of Assets and Liabilities

Assets Liabilities

Liquidity

Risk

Return

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Weighted Averages Interest Rates on Loans and Deposits in Kuwait )%(

Year 2004 2005 2006 2007 2008 2009 2010 Average

W.A. Loan Rate

5.637 7.497 8.579 8.539 7.578 5.885 5.14 6.7855

W.A. Deposit Rate

2.655 3.469 4.925 5.451 4.806 2.895 2.318 3.8675

Interest Rate Spread

2.982 4.028 3.654 3.088 2.772 2.99 2.822 2.918

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The process of asset transformation and providing services )e.g. check clearing, credit analysis( is similar to the production process by firms.

If the bank produces at low cost and earns higher return on its assets, then it makes profit, vice versa.

A tool used in analyzing bank operation is the

T-account: a simplified balance sheet that lists only changes occurring in balance sheet items from a transaction.

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Example 1 1. A person opens a checking account at “First

National Bank )FNB(” with $100 in cash. This shows up as a liability on the bank balance sheet.

If the bank keeps the $100 as cash, this raises the bank assets )vault cash(.

First National Bank

Assets Liabilities

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Since the cash is part of the bank’s reserves, we can rewrite the T-account as follows:

Assets Liabilities

First National Bank

Result: opening a checking account with cash increases the bank’s reserves equal to the increase in checkable deposits.

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Example 22. If a person opens a checking account with a $100

check written on her account at another bank “Second National Bank )SNB(.”

FNB is owed $100 by SNB. This asset for FNB appears in its T-account as cash items in process of collection.

FNB deposits the check in its account at the central bank who transfers $100 of reserves from SNB to FNB.

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First National Bank

Assets Liabilities

The final balance sheet positions of the two banks are as follows:

First National Bank

Assets Liabilities

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Second National Bank

Assets Liabilities

Result: when opening a checking account with a check, the bank receiving the deposit gains reserves equal to the amount of the check, while the bank on which the check is written loses reserves by the same amount.

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Making profit If FNB receives a $100 checkable deposit. If the required reserve ratio is 10%. The required reserves are $_____, and the excess reserves

are $_____. The T-account becomes:

First National Bank

Assets Liabilities

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If the FNB decides not to hold excess reserves, it makes a loan of $____ )Why not $100?(, the T-account becomes:

First National Bank

Assets Liabilities

If the bank charges 10% on loans, managing each account costs $3, paying 5% interest on each account. What’s the bank's profit from the two transactions?Profit =

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Gulf Bank Income Statement )2007, million KDs( A. Interest income )from loans and interbank deposits( 315.3

B. Interest expenses )on deposits and borrowings( 208.7

Net Interest income )A-B( 105.5

Fees and commissions 23.4

Net gains from dealing in foreign currencies 14.9

Dividend income 0.77

Income from disposal of investments available for sale 48.7

Operating Income 195.6

Staff expenses 22.1

Occupancy costs 1.8

Depreciation 2.2

Operating expenses 36.4

Operating Profit 135.3

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Continue…Income StatementOperating Profit 135.329

Contribution to Kuwait Fund for the Advancement of Sciences 1.354

Directors’ emoluments 0.108

National Labor Support Tax 3.347

Zakat .083

Net Profit 130.437

Earnings per Share )Fils( 122.142

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GENERAL PRINCIPLES OF BANK MANAGEMENT

1. Liquidity Management:Maintaining enough liquid assets to meet obligations to depositors and to the central bank.

2. Asset Management:Managing assets to achieve diversification and minimize rate of default and interest rate risk.

3. Liability Management:Acquire funds at the lowest possible cost.

4. Capital Adequacy Management:

Maintaining the appropriate capital )net worth( to meet central bank regulations and prevent bank failure.

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FIRST: LIQUIDITY MANAGEMENT

Management of bank reserves. Two concerns:

1( excess reserves and 2( insufficient reserves.

 Example )1(: Bank holds excess reserves

 Assume the bank's initial balance sheet is as follows:

                             First National BankAssets Liabilities

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If required reserve ratio is 10%, the required reserves are: _____. But since the bank's total reserves are ______, the excess reserves are _____.

If depositors withdraw $10 million, the bank's balance sheet becomes:

  First National Bank

Assets Liabilities

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The bank lost $_____of deposits and

$_____of reserves. The required reserves declined from $______ to $______ )Why?(.

Excess reserved declined from $______ to $______ )why?(

  Result:

If a bank has excess reserves, a decline in its deposits does not necessitate )leads to( changes in other parts of its balance sheet )Except:___ & ___(

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Example )2(: Bank holds no excess reserves Assume the bank's initial balance sheet is as follows:

 First National Bank

 

If depositors withdraw $10 million, the bank's balance sheet becomes:

  First National Bank

Assets Liabilities

Assets Liabilities

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The bank lost $____of deposits and $____of reserves.

Total reserves declined from $______ to $_______.

Required reserves should be $______, but the bank has $_____ reserves )is there a problem?(

What do we mean by a problem?

1.

2.

To get funds to meet reserve requirements, the bank has four options:

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 1. Borrow from other banks

)from the __________market(, or from corporations.

In this case the balance sheet becomes:

                            First National Bank

Assets Liabilities

 The cost of this option is the amount of interest paid on the loans.

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 2. Sell securities

 Sell securities and deposit the revenues with the central bank, the balance sheet becomes:

First National Bank

Selling securities has brokerage costs, they are low for government securities because they are very liquid, but may be high for other securities.

Assets Liabilities

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3. Borrow from the central bank Borrow from the C.B., the balance sheet is:                             First National Bank

Two costs:A. The amount of interest paid on the loan.B. Indirect Costs: 1( The C.B. discourages too muchborrowing, 2( the C.B. carefully examines the bank,

and 3( the C.B. may close the discount window.

Assets Liabilities

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4. Reducing Loans

 The bank can reduce loans in two ways:

1( don't renew short term loans and 2( sell loans to other banks and deposit the revenues with the C.B. The balance sheet become:

First National Bank

Assets Liabilities

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This is the costliest way because:

1( Not renewing loans discourages future business with borrowers.

2( Selling loans may require banks to sell them at lower value to encourage other banks to buy them )why?(.

3( The bank will forego potential interest on loans.

General Result:

1( Excess reserves are insurance against the costs associated with deposit outflows.

2( The higher the costs to provide required reserves, the more excess reserves banks will want to hold.

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SECOND: ASSET MANAGEMENT Banks manage their assets to maximize profits by:  1. Assess creditworthiness of potential borrowers to

avoid costly defaults. )Banks usually conservative, default rate is low( 2. Buying securities with high returns and low risks. 3. Diversify assets: Securities: Short term )T-bills( and long term

)Government bonds( Loan portfolio )commercial, industrial, consumer,

real estate(.

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Kuwait’s Banks: Assets (Million KDs)

Year Cash

Sight Deposits

with CBK

Time Deposits

With CBK

CBK Bonds

Claims on

Gov’t

Claims on

Private Sector

Foreign Assets

Local Interbank Deposits

Total

2004 75.3 174.9 126.0 - 2750.0 10885.8 3192.0 1404.8 19144.2

2005 105.9 111.7 440.4 124.0 2463.1 12936.7 3794.1 1014.0 21611.6

2006 148.6 50.2 926.2 356.0 2165.1 16148.2 5245.8 1290.8 26990.0

2007 115.2 483.6 813.0 590.6 1911.8 21820.0 7632.6 1389.8 35553.3

2008 161.4 371.3 97.3 374.5 1996.4 25450.3 8796.0 671.9 39241.0

2009 168.1 224.8 872.6 1017 1921.7 27018.7 7354.1 854.7 40320.7

2010 163.7 78.1 1373.7 1344 1910.3 27526.8 7272.4 906.3 41374.8

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Maturity and the Volatility of Bond Returns

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 4. Manage assets to ensure liquidity by holding sufficient liquid assets in case of large deposit outflows.

For example, T-Bills are so safe and liquid that they are considered "secondary reserves." 

  The bank has to balance liquidity )cash( against

increased earnings from less liquid assets )loans(.

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Capital Adequacy Management

Banks choose the amount of capital they hold for three reasons:

1. It Helps Prevent Bank Failure:

Bank failure occurs when a bank cannot satisfy its

obligations to pay its depositors and creditors and so

goes out of business.

Example

Consider two banks, one with low capital to assets ratio and the other high ratio.

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Assets Liabilities

Assets Liabilities

   High Capital Bank

   Low Capital Bank

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Assets Liabilities

Assets Liabilities

   High Capital Bank

   Low Capital Bank

If the two banks lose $ 5 million of their loans, their assets and capital will decline too by the same amount.The new balance sheets become as follows:

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The high capital bank is in a good situation because its net worth )capital( is positive )$5 m.(.

The low capital bank is in a bad situation because its net worth is negative )-$1 m.(.

The value of its assets is less than its liabilities, therefore it is insolvent )bankrupt(:

It does not have enough assets to pay off holders of its liabilities )depositors, creditors(.

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2. It Affects Returns to Equity Holders

Bank owners need measures indicating if the bank is

being managed well or not.

Return on Assets )ROA(:

ROA = net profit after taxes / assets

The ROA shows how efficiently a bank is being run by

indicating how much profits are generated on average

by each dollar of assets.

 Return on Equity )ROE(:

ROE = net profit after taxes / equity capital

The ROE shows how much the bank earns on equity

investment.Dr. Reyadh Faras

Equity Multiplier )EM(: EM = assets / equity capital

It is the amount of assets per dollar of equity capital.It shows the direct relationship between ROA and

ROE:

 ROE = ROA X EM

The formula shows what happens to the return onequity when a bank holds a smaller amount of equitycapital for a given amount of assets.

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ExampleThe high capital bank: EM = $___ m. / $___ m.= The low capital bank: EM = $___ m. / $___ m.=

If ROA is 1%, then:

ROE for the high capital bank = ___% X ___ = ___%

ROE for the low capital bank = ___% X ___ = ___%

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Equity holders of the low capital bank are happierbecause they have a return more than twice higher.

Thus, bank owners don't like holding a lot of capital

) because it reduces ROE(.

Result:

Given the ROA, the lower the bank capital, the higher the ROE. This show that there is a trade-off between safety and returns.

3. Bank Capital RequirementsBanks hold capital because they are required by law to do so.

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Managing Interest Rate Risk

High volatility in interest rates makes banks exposed to interest- rate risk:

The possible reduction in returns associated with changes in interest rates.

First National Bank

Assets Liabilities

Rate-sensitive Assets Rate-sensitive Liabilities

Fixed -rate Assets Fixed-rate Liabilities

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ExampleIf interest rate rises from 10% to 15% ) Δ = ___%(Δ Profit = Δ income – Δ costΔ income = Δ interest  X rate sensitive assets                = ___%   X $ ____ million  =  $ ___ million Δ cost = Δ interest  X rate sensitive liabilities            = __%   X $ ___ million  =  $ ___ million

Δ Profit = However, if interest rate falls by 5%, profit ____ by

$___million.

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Gap Analysis- It is a measurement of the Sensitivity of bank profits

to changes in interest rates.- The gap can be calculated by subtracting the

amount of rate sensitive liabilities from the amount of rate sensitive assets.

- Gap = RSA – RSL = ____ – ____ = $ ____ million

Δ profit = Δ interest X Gap

 Δ profit = __%  X  $___ million = $___ million ResultIf a bank has more rate-sensitive liabilities than

assets, a rise in interest rates reduces bank profits, while a decline in interest rates raises profits.

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The Effect of a change interest on Profits

RSL > RSA RSA > RSL RSA = RSL

Increase in i

Decrease in i

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Duration Analysis

- Examines the sensitivity of market value of the bank's total assets and liabilities to changes in interest rates.

- Uses the average duration of assets and liabilities tomeasure the change in net worth for a given change

in the interest rate.

Assumptions:- Average duration of assets 3 years and liabilities 2.- Assets are $100 million and liabilities are $90

million.

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Example

If interest rate rises by 5%.

Δ Net Worth = Δ $ assets - Δ $ Liabilities

% Δ Assets = - Δ interest X Average Asset duration

= _____% X ______= _____%

Δ $ Assets = % Δ Assets X $ Assets

= _______% X $______ = $_______

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% Δ Liab’s = - Δ interest X Average Liab’s duration

= _____% X _____= ____%

Δ $ Liab’s = % Δ Liab’s X $ Liab’s

= _______% X $______ = $_______

Δ Net Worth = $ _____ - $ ______ = $ _______

- However, a 5% decline in interest rates _____ net worth by $_____.

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The Effect of a change interest on Capital

AD > LD AD < LD AD = LD

Increase in i

Decrease in i

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Managing Credit Risk1. Screening and Monitoring

- Screening

- Specialization in Lending

- Monitoring and Enforcement of Restrictive Covenants

2. Long-Term Customer Relationships

3. Loan Commitments

4. Collateral and Compensating Balances

5. Credit Rationing

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Off-Balance-Sheet Activities1. Loan sales

2. Generation of Fee income from

A. Foreign exchange trades for customers

B. Servicing mortgage-backed securities

C. Guarantees of debt

D. Backup lines of credit

3. Trading Activities and Risk Management Techniques

A. Financial futures

B. Financial options

C. Foreign exchange

D. Swaps

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