lecture notes commercial bank management program mm banking stie perbanas

Lecture Notes

Commercial Bank Management

Program MM BankingSTIE Perbanas

• Source of funds (liabilities):• Deposits (demand, savings and time) – third party funds (Dana Pihak

Ketiga/DPK)

• Borrowed funds, subordinated notes and bonds

• Capital

• Bank uses of funds (assets):• Cash assets – vault cash, reserve at central bank, balance on other

banks• Federal funds sold dan reverse repo • Investments – government bonds/securities• Loans and leases

Total assets = total liabilities + capital

Bank balance sheet

Deposits• Deposits are the principal source of funds• Demand deposits

• Checking/ giro account – owners entitled to write checks or giro• Savings deposits/accounts• Money market deposit accounts

• Time deposits• Certificates of deposits• Negotiable certificate of deposits (NCD)

Borrowed funds USA

• Federal funds – o/n interbank call money • Repos• Banker’s acceptance• Federal Reserve Bank loans – short term (15 days)

Bank balance sheet Source of funds

Indonesia• Interbank call money (Pasar Uang Antar Bank/PUAB)

• BLBI (but no longer since UU

23/1999)


• The bulk of commercial bank funds - about two-thirds of the total – comes from deposits

• Principal nondeposits sources of funds for banks include purchases of reserves from other banks, securities repurchace agreements, and the issuance of capital notes.

• Recently banks have turned to new nondeposit funds sources, including floating-rate CDs and notes sold international markets, sales of loans, securitization of selected assets.

• Equity capital (or networth) applied by a bank’s stockholders provides only a minor portion of (around 10% on average, but at least 8% according Basle II) total funds for most banks today.


Securitizations of bank loans to raise funds

Bank loansBank loans

Some loans removedFrom balance sheet, pooled,

and placed under the control ofseparate corporation or trust

Some loans removedFrom balance sheet, pooled,

and placed under the control ofseparate corporation or trust

Securities are issuedagainst the pool ofloans and sold to

capital market

Securities are issuedagainst the pool ofloans and sold to

capital market

Proceeds of security sales flow back to the bank as a new sorce of funds

Proceeds of security sales flow back to the bank as a new sorce of funds

Cash assets – vault cash, reserve or deposit at central bank, balance on other banks• Required reserves• Excess reserves

Investment• Government bonds/bills• Local government securities• Central bank bills (SBI in Indonesia)

Loans and leases• Loans are primary bussiness of commercial banks• Loand are the most profitable but subject to greater default risk• May be secured (with collateral) or unsecured• Fixed rate or floating rate loans• Types of loans: commercial and industrial loans, interbank loans, real estate

loans, agricultural loans, consumer loans (loans to individuals, e.g. credit card)• Lease financing

Bank balance sheet Uses of funds


• Cash (primary reserves) is the banker’s first line of defense againts withdrawals by deposits and customer demand for loans

• Commercial banks hold securites (mostly short-term) acquired in the open market as an investment and as a secondary reserves to help meet short-term cash needs.

• Loans are among the highest yielding assets a bank can add to its portfolio, and they often provide the largest portion of traditional banks’ operating revenue.

Loans pricing

• Subject to risk assessment• The prime rate – benchmark or base rate (charged to the most creditworthy customers)

• Base rate loan pricingr = BR + DR + TM + CF

r = individual customer loan rateBR = the base rateDR = adjustment for default risk above base

rate customerTM = adjustment for term to maturityCF = competitive factor

• Cost of loanable fund


Basic Operation of a Bank

Assets Liabilities

Reserves• Vault cash + 100• Cash in the process of collection +100

• Checkable dep Melisa + 100Felix + 100

Assets Liabilities

Reserves • Vault cash + 100• Giro acct at Central bank + 100


Assets Liabilities

Reserves• Giro acc at Central bank - 100

• Checkable dep Felix - 100

After collection (through check clearing process - interbank), T-acc of the two banks:

Lippo Bank

BCA

Basic operation of a bank

When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reservesWhen a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves

Basic operation of a bank

• What next Lippo Bank is going to do with additional reserves of Rp 200 million?- Suppose the required reserves (imposed by the central bank) is 10%, there will

be 90% of excess reserves available to lend. Lippo Bank

Assets Liabilities

Reserves • Required reserves + 20• Excess reserves + 180

• Checkable dep Melisa + 100 Felix + 100

Assets Liabilities

Reserves • Required reserves + 20• Excess reserves + 180 - 180Loans + 180


Basic operation of a bank: Deposits or Money creation


•Let assume the debtor receiving Rp180 million from Lippo Bank put the money back at her account at the same bank; deposits at Lippo bank will increase by the same amount, the loan operation will continue.

•Let assume the debtor receiving Rp180 million from Lippo Bank put the money back at her account at the same bank; deposits at Lippo bank will increase by the same amount, the loan operation will continue.

Assets Liabilities

Reserves • Required reserves 10% * 200 + 20 10% * 180 + 18• Excess reserves + 180 - 180 + 162.Loans to PT X + 180 to PT Y + 162

• Checkable dep Melisa + 100 Felix + 100

PT X + 180 PT Y + 162

Lippo BankLippo Bank


• Banks have the power to create money in the form of new checkable deposits, credit card lines, debit cards, and other immediately spendable funds.

• The banking system as a whole can create a volume of money equal to a multiple of any excess reserves deposits with it simply by making loans and purchasing securities.

• Each bank reserves may divided into 2 categories:- Required reserves- Excess reserves

• The distinction between excess and required reserves is important because it plays a key role in the growth of credit in the economy and the creation of money in the banking system.

• When all excess reserves extended (making loans), the banking system is called “loaned-up”.

General Principle of Bank Management

1. Liquidity management• Make sure enough cash to meet deposit withdrawal• Too much cash is costly

2. Assets management• Acquiring assets with low risk• Diversifying assets holdings

3. Liability management• Acquiring funds with low cost

4. Capital management• Maintain capital adequacy

Liquidity management

• Banks need to maintain adequate reserves to meet deposit withdrawal and reserve requirement

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

• What if a bank holds insufficient reserves?

- Either fail to meet deposit withdrawal- Or fail to meet required reserves penalty

• What that bank will do?

- it can either borrow from other banks (fed funds in US and PUAB in Indonesia),

- or sell securities (T-bills/bonds), - or borrow from the central bank (discount rates).

17-16

Reserves requirement = 10%, Excess reserves = Rp10 million

Assets (Rp million) Liabilities (Rp million)

Reserves 20 Deposits 100

Loans 80 Bank Capital 10

Securities 10

Liquidity managementLiquidity management

Assume: Deposit outflow of Rp10 million

Assets (Rp million) Liabilities (Rp million) Reserves 10 Deposits 90 Loans 80 Bank Capital 10

Securities 10

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

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

If No excess reserves Assets (Rp million) Liabilities (Rp million)


Loans 90 Bank Capital 10

Securities 10

Suppose Deposit outflow of $10 million

Assets (Rp million) Liabilities (Rp million) Reserves 0 Deposits 90 Loans 80 Bank Capital 10 Securities 10


1. Borrow from other banks or corporations

Assets (Rp million) Liabilities (Rp million)


Loans 90 Borrowings 9

Securities 10 Bank Capital 10

2. Sell securities Assets Liabilities

Reserves 9 Deposits 90 Loans 90 Bank Capital 10

Securities 1

Liquidity managementWhat the bank will do?

Liquidity managementWhat the bank will do?

17-19

Excess reserves are insurance against above 4 costs from deposit outflows; Banks hold excess reserves even though loans or securities earn a higher return. (Empirical evidence in Indonesia, RR=5%, average ER= 2%)

3. Borrow from the central bank Assets (Rp million) Liabilities (Rp million)


Loans 90 Discount Loans 9

Securities 10 Bank Capital 10

4. Call in or sell off loans

Assets (Rp million) Liabilities (Rp million) Reserves 9 Deposits 90 Loans 81 Bank Capital 10 Securities 10


Assets management

• Maximizing profits by seeking the highest returns possible for loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets

• Four ways in accomplishing these three goals:1. Find borrowers who will pay high interest rates and unlikely to

default – the role of bank’s loan officers. 2. Purchase securities with high returns and low risk.3. Diversifying assets portfolio (short, long-term) to lower risk –

“do not put your eggs into one basket”.4. Manage liquidity of the assets, easy to get cash to meet

reserve requirement – how much excess reserves must be held to avoid cost from a deposit outflow.

Liability management

• Managing the source of funds, from deposits, to CDs, to other debt – banks no longer depends primarily deposits - When see loan opportunities, borrow or issue CDs to acquire funds

• So a bank can target goals for their assets growth and acquire funds by issuing liabilities in the money market or by borrowing from another bank (interbank money market – o/n federal funds in the US market).

• Flexibility in the liability management and the search for higher profits have stimulated banks to increase proportion of loans (which earn higher income) in their total assets.

Capital management

• Bank capital is a cushion that prevents bank failure, in case the bank cannot satisfy its obligation to pay its depositors or creditors

• The higher is bank capital, the lower is return on equity

- ROA = Net Profits/Assets

- ROE = Net Profits/Equity Capital

- EM (Equity multiplier) = Assets/Equity Capital

- ROE = ROA EM

- Capital , EM , ROE

Capital management

• Tradeoff between safety (high capital) and ROE• Banks also hold capital to meet capital adequacy

requirements imposed by authorities• Strategies for Managing Capital

- Sell or retire stock- Change dividends to change retained earnings- Change asset growth

Off-balance sheet activities

• In today’s more competitive environment, off-balance sheet activities have grown to be a source of bank’s profit – activities that affect bank profits but do not appear on the bank balance sheets.

• Off-balance activities generate income: • Fee income from

• Foreign exchange trades for customers• Servicing mortgage-backed securities• Guarantees of debt• Backup lines of credit

• Financial futures and options • Foreign exchange trading• Interest rate swaps• Loan sales

• All these activities involve risk• Payments services on behalf of customers – low risk

Measuring Bank Performance

• Four dimensions of bank performance today:- The bank’s market value or stock price- The bank’s rate of return or profitability ratios- The bank’s risk exposure- The bank’s operating efficiency.

• Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts:- Operating Income- Operating Expenses- Net Operating IncomeNote how this is different from, say, a manufacturing firm’s income statement.

Banks' Income Statement

Bank’s income statement & Balance sheetBank Central Asia

Year to 31 Dec 2006 (Rp trio)

Average earning assetsNet interest marginNet interest incomeFees and commissionsOther incomeTotal operating incomeOperating expensesPreprovision profitLoan loss provisionPretax profitTaxNet profitAverage shares (million)EPS (rp)DPS (rp)Divident payout ratio

148.40 6.1%9.032.030.60

11.655.116.53

(0.60)6.00

(1.82)4.24

12.320.340.1550%

Profit & Loss StatementProfit & Loss Statement

At 31 Dec 2006 (Rp trio)

AssetsCash on handDeposits at BIPlacementsMarket securitiesGovernment bondsNet loansFixed assetsOtherTotal assetsLiabilitiesCustomer depositsBorrowingsOther liabilitiesTotal liabilitiesEquityTotal liabilities & equity

5.4919.176.30

28.2749.1459.692.213.26

176.80

153.760.742.64

158.7318.07

176.80

Balance sheetBalance sheet

Selected banking performance indicators

• Capital adequacy ratio (CAR) – capital/risk weighted assets

• Earning assets quality ratio – classified earning assets/total earning assets

• Return on assets ratio – annual profit before taxes/average assets

• Operations expenses to operations income ratio

• Liquid asset to liquid liabilities ratio

• Loan to deposit ratio (LDR) – total credit/third party funds (deposits)

• Non-performing loan ratio (NPL) – credits that are sub-standard,dubtful and loss/ total credits

• Net interest margin (NIM) ratio –net interest income/average earning assets

Note: See Indonesian Banking Statistics (Bank Indonesia monthly publication)

Recent Trends in Bank Performance Measures

• ROA = Net Profits/ Assets

• ROE = Net Profits/ Equity Capital

• NIM = [Interest Income - Interest Expenses]/ Assets

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows historical averages for key bank performance measures in US.

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows historical averages for key bank performance measures in US.

lecture notes commercial bank management program mm banking stie perbanas

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