player's manual - college of business · operating cost example #1: ... probanker provides...

Player's Manual

for Flannery and Flood's ProBanker

Mark J. Flannery

Mark D. Flood

Table of ContentsSome Definitions ..................................................................................................... viiiAbout the Authors ...................................................................................................... ix1. Introduction ............................................................................................................ 1

1.1. Two Modes of Operation: Autobank and Competitive .......................................... 11.2. Managing a Bank: The Basics .......................................................................... 31.3. Managing a Bank: Some Complications ............................................................. 5

1.3.1. From Profits to Market Value ................................................................ 51.3.2. Operating Costs .................................................................................. 61.3.3. Loan Losses ....................................................................................... 71.3.4. Reserve Requirements ......................................................................... 71.3.5. Advertising ........................................................................................ 8

1.4. How to Use This Manual ................................................................................ 92. Operating the Player Software .................................................................................. 11

2.1. Registering to Use Probanker ........................................................................ 112.2. Changing Your Profile ................................................................................. 122.3. Playing Games ............................................................................................ 142.4. Generating Reports ...................................................................................... 162.5. Downloading Bank Data to a Spreadsheet ........................................................ 172.6. Entering Decisions ...................................................................................... 172.7. Using Autobank to Learn About ProBanker ...................................................... 192.8. Help ......................................................................................................... 19

3. ProBanker's Financial Structure (Overview) ................................................................ 213.1. The Balance Sheet ....................................................................................... 213.2. The Income Statement .................................................................................. 243.3. CEO Decisions and ProBanker's Timing Convention .......................................... 26

4. ProBanker's Financial Structure (Details) ................................................................... 284.1. General Account Features ............................................................................. 284.2. Determining the Quantity of Rate-Set Items ..................................................... 294.3. Operating Costs, Part I ................................................................................. 304.4. Operating Costs, Part II (optional) .................................................................. 31

4.4.1. Operating Cost Example #1: Fixed-rate loans ......................................... 314.4.2. Operating Cost Example #2: Multi-period mortgage loans ........................ 31

4.5. Detailed Account Descriptions ....................................................................... 324.5.1. Asset Accounts ................................................................................. 324.5.2. Liability Accounts ............................................................................ 34

4.6. Loan Losses and Non-Performing Loans .......................................................... 364.6.1. Controlling Credit Quality .................................................................. 374.6.2. Accounting for Loan Losses ............................................................... 374.6.3. Bank Examinations and the LLA ......................................................... 38

4.7. Macroeconomic Effects on Your Bank ............................................................ 384.8. Bank Leverage and Purchased Funds .............................................................. 394.9. Capital and Capital Adequacy ........................................................................ 404.10. Market Value of Bank Equity ....................................................................... 434.11. Balancing Your Balance Sheet ..................................................................... 44

4.11.1. When Assets Initially Exceed Liabilities .............................................. 444.11.2. When Liabilities Initially Exceed Assets .............................................. 45

4.12. Reserve Requirements ................................................................................ 455. The Effects of Your Decisions .................................................................................. 47

5.1. Quantities to Choose .................................................................................... 475.1.1. Initial Reserve Allocation ................................................................... 475.1.2. Federal Funds Sold ........................................................................... 475.1.3. Federal Funds Purchased .................................................................... 485.1.4. Negotiable CDs To Issue (three maturity choices) ................................... 48

iv

5.1.5. New 8-Quarter Bonds To Purchase ...................................................... 485.1.6. Bonds to Sell (seven maturity choices) .................................................. 48

5.2. Rates to Choose .......................................................................................... 485.2.1. Fixed Rate Corporate Loans ................................................................ 485.2.2. Floating Rate Loan Spread .................................................................. 485.2.3. Installment Loan Rate ........................................................................ 495.2.4. Mortgage Loan Rate .......................................................................... 495.2.5. Retail CDs ....................................................................................... 495.2.6. Passbook Saving Accounts ................................................................. 495.2.7. IRA Accounts (Long-term retail time deposits) ....................................... 495.2.8. Demand Deposits (Retail and Corporate) ............................................... 50

5.3. Advertising Decisions (seven categories) ......................................................... 505.4. Capital Structure Decisions ........................................................................... 50

5.4.1. Number of Shares to Sell .................................................................... 505.4.2. Total Dividends ................................................................................ 50

5.5. Other (Miscellaneous) Decisions .................................................................... 505.5.1. Provision for Loan Losses .................................................................. 505.5.2. Corporate Loan Standard .................................................................... 515.5.3. Percentage of Cost Charged to Demand Deposits (Retail and Corporate) ..... 51

6. Analyzing Your Bank's Condition and Making Good Decisions ...................................... 526.1. Pricing Rate-Set Assets and Liabilities ............................................................ 52

6.1.1. Obtain Adequate Loanable Funds ........................................................ 526.1.2. The All-Inclusive Cost of Deposits and Other Liabilities .......................... 536.1.3. The Net Return on Loans and Other Assets ............................................ 55

6.2. Managing Interest Rate Risk .......................................................................... 586.3. Customer Relationships and Effective Maturities ............................................... 596.4. Managing Your Capital Ratio ........................................................................ 606.5. Estimating the Rate-Sensitivity of Loan Demands and Deposit Supplies ................ 60

6.5.1. Slope Estimates from Competitive Mode Outputs ................................... 616.5.2. Slope Estimates from Autobank Outputs ............................................... 63

A. Answers to Frequently Asked Questions .................................................................... 66B. Sample Reports for the Regional Low-Cost Template after Q0 ....................................... 78

B.1. Summary Balance Sheet ............................................................................... 78B.2. Balance Sheet ............................................................................................ 78B.3. Income and Expense Report .......................................................................... 80B.4. Capitalization Report ................................................................................... 82B.5. Loan Performance Report ............................................................................. 83B.6. Bond Portfolio Report ................................................................................. 83B.7. Regional Interest Rate Report ........................................................................ 83B.8. Bond Market Report .................................................................................... 84B.9. Economic Environment Report ...................................................................... 84B.10. Performance Report ................................................................................... 85

Player's Manual

v

List of Figures1.1. ProBanker simulation cycle, autobank mode ............................................................... 11.2. ProBanker simulation cycle, competitive mode ........................................................... 23.1. Event Timing in ProBanker ................................................................................... 265.1. Game Decisions Page ........................................................................................... 476.1. Estimated Supply Curve for IRA Balances ............................................................... 626.2. Marginal and Average Costs of Retail CDs .............................................................. 64

vi

List of Tables1.1. Autobank versus Competitive Modes of Play .............................................................. 21.2. Basic Bank Balance Sheet ....................................................................................... 31.3. Alternative BabyBank Balance Sheets ....................................................................... 41.4. Alternative BabyBank Income Statements .................................................................. 41.5. Revised Income Statement, to Include Noninterest Expenses ......................................... 61.6. Revised Income Statement, to Include Noninterest Expenses and a Provision for Loan Losses................................................................................................................................. 71.7. Revised Balance Sheet, to Include Cash Reserves ........................................................ 71.8. Revised Income Statement, to Reflect Cash Reserves ................................................... 81.9. Effect of Advertising on Balance Sheet in , Given Decision Set "A" ................................ 81.10. Effect of Advertising on Income Statement, Given Decision Set "A" (compare to ) .......... 92.1. Summary Information about Entering Decisions ........................................................ 183.1. Summary Balance Sheet ....................................................................................... 223.2. ProBanker Account Characteristics ......................................................................... 243.3. A Stylized Version of ProBanker's Income and Expense Report ................................... 254.1. Transaction Costs Associated with ProBanker Accounts ............................................. 324.2. Loan Performance Report ..................................................................................... 374.3. Bond Portfolio Report .......................................................................................... 394.4. Capitalization Report ........................................................................................... 424.5. Performance Report (Compares Banks) ................................................................... 446.1. Loan Performance Report ..................................................................................... 566.2. Maturity Gap Worksheet ....................................................................................... 586.3. Excerpt from Full Balance Sheet ............................................................................ 626.4. Marginal Cost Estimates for IRA Balances, using Competitive Mode output ................... 636.5. Marginal Cost Estimates for Retail CD Balances, using Autobank Mode output .............. 64

vii

Some DefinitionsGame

One or more banks operating in the same simulated regulatory andmacroeconomic environment. Games may be either Competitive(many banks interacting) or Autobank (one bank competes againstpre-programmed competitors) Modes.

TemplateThe basis for a Game. Players use a Template to create an AutobankGame; the Administrator uses a Template to create a set of identicalbanks that will operate in the same economy.

RegionA group of banks that compete directly with one another for loansand most types of deposits. Sometimes called a "Market."

EconomyA group of banks operating under the same macroeconomic condi-tions (in particular, GDP and the riskless term structure). Usually, aneconomy is organized into several distinct Regions.

viii

About the AuthorsMark J. Flannery

Mark J. Flannery has held an Eminent Scholar Chair (first the "Barnett" chair, now "BankAmerica") inFinance at the University of Florida since 1989. He previously served on the faculties of UNC-ChapelHill, the University of Pennsylvania's Wharton School, and (as a visitor) at the London Business Schooland the University of New South Wales. For five years, he was a Research Adviser to the Federal Re-serve Bank of Philadelphia. He was elected to the American Finance Association's Board of Directors in1999, and to the Financial Management Association Board in 2000. He holds degrees in economics fromPrinceton and Yale Universities. Flannery presently edits the Journal of Money, Credit and Banking,was a founding editor of the e-periodical FMA-Online, and serves as an Associate Editor for six otheracademic journals. He has published extensively in academic and practitioners' finance and economicsjournals. The majority of his work concerns the management and regulation of financial institutions, buthe has also studied problems in information economics, capital structure, and asset market equilibrium.Early in his career, he co-authored (with Dwight Jaffee) the first scholarly economic analysis of the"cashless society". In addition to his research activities, Flannery has consulted with private banks andgovernment agencies, and served on the Board of the Barnett Bank of Alachua County (a $425 milliondollar community bank).

Mark D. FloodMark D. Flood did his undergraduate work at Indiana University in Bloomington, where he majored infinance (B.S., 1982), and German and economics (B.A., 1983). In 1990, he received his Ph.D. in financefrom the Graduate School of Business at the University of North Carolina at Chapel Hill. He was a Vis-iting Scholar and Economist in the Research Department of the Federal Reserve Bank of St. Louis from1989 to 1993. From 1993 to 2003, he served as an Assistant Professor of finance at Concordia Uni-versity in Montreal, a Visiting Assistant Professor of Finance at the University of North Carolina atCharlotte, and a Senior Financial Economist in the Division of Risk Management at the Office of ThriftSupervision. He is currently a Senior Financial Economist with the Federal Housing Finance Board inWashington, D.C. His research interests include financial markets and institutions, securities market mi-crostructure, and bank market structure and regulatory policy. His research has appeared in many schol-arly journals, including the Review of Financial Studies, the Journal of International Money and Fin-ance, and the St. Louis Fed's Review.

ix

Chapter 1. IntroductionSuccessful managers of financial services firms must understand the economic forces affecting theirbusinesses. While many analytical tools can be learned from a textbook, a manager's real challenge liesin applying those tools to the "real world." ProBanker provides this opportunity in a controlled, dynamicframework, which challenges students and practitioners to integrate their finance training with real-world situations. Unlike traditional learning methods such as textbooks, lectures, or static case studies,the ProBanker environment responds to your decisions. Your actions affect both your competitors' andyour own profitability.

In ProBanker, each player (or team of players) takes the role of the Chief Executive Officer (CEO) at adomestic U.S. bank. Players choose their bank's portfolio composition, loan and deposit pricing, creditrisk exposure, maturity (duration) gaps, and capital structure, while complying with important regulatoryrestrictions. Your goal is to maximize shareholder wealth by producing high, steady earnings. Successrequires that you understand financial decision making -- and apply it better than your competitors do.

Unlike a textbook's end-of-chapter question or a standard problem set, ProBanker doesn't clearly identi-fy all the variables you need to know in order to make good financial decisions. You will apply your fin-ancial knowledge in a (realistic) world of incomplete or imprecise information. Managers must identifythe facts they need, figure out how to collect that information, and assess how confident they should beabout the accuracy of available information. In other words, this sort of simulation game challenges youto apply financial theory in a complex, uncertain environment -- much as you will when making realbusiness decisions.

1.1. Two Modes of Operation: Autobank and Com-petitive

Your administrator may choose to run ProBanker in one (or both) of two Operating Modes, AutobankMode and Competitive Mode.

In Autobank Mode, you play "against the machine." You implement the full set of financial decisions,and your bank competes with a number of market rivals. However, the behavior of your Autobank rivalsis pre-programmed. They will not react to your product pricing and marketing strategies. Autobank's ab-straction from competitors' responses permits you to learn about ProBanker's program features and eco-nomic characteristics.

Figure 1.1. ProBanker simulation cycle, autobank mode

Figure 1.1 illustrates ProBanker's Autobank Mode of play. As soon as your decisions are ready, you runthe simulation yourself, and see the results within a few seconds. You can learn a lot in a fairly shortperiod of time. Autobank can "turn back time". This feature permits you to simulate a variety of pricing,advertising, and funding decisions, starting from the same point in time. For example, set the installment

1

loan rate to 11% for four successive quarters. Then return to the initial balance sheet and simulate theimpact of a lower or higher loan rate over the same four periods. Don't be afraid to try something radic-al: at the worst, you can reset Autobank to its initial condition whenever you like.

Figure 1.2. ProBanker simulation cycle, competitive mode

You will use ProBanker's Competitive Mode of operation to compete directly with other bankers in yourcourse. Your Administrator will divide the banking industry (i.e., your course) into separate geographicRegions. Each bank competes directly with the other banks in its Region. Banks in different Regionshave no direct effect on one another, although they do operate under the same macroeconomic condi-tions (GDP growth and market interest rates).

Figure 1.2 illustrates the Simulation Cycle in ProBanker's Competitive Mode. Within a competitive Re-gion, all banks' decisions interact in a competitive simulation. Your Administrator cannot run the simu-lation until all banks have submitted their decisions. It is therefore imperative that all management teamsenter and save their decisions in a timely manner. After the Administrator has simulated the next calen-dar quarter, the results become available through Reports you access with your web browser.

Table 1.1. Autobank versus Competitive Modes of Play

Step Autobank Mode Competitive Mode

1 Management team selects a Template and "Cre-ates a Game" from it. (See Section 2.3.)

Administrator selects starting financial condi-tion for all banks in the "economy." Each man-agement team controls a single bank.

2 Each player or team generates reports from thequarter just simulated, and assesses their bank'scondition.

Each player or team generates reports from thequarter just simulated, and assesses their bank'scondition.

3 Players make decisions and save them to theProBanker website's database.

Players make decisions and save them to theProBanker website's database before the Ad-ministrator's announced deadline.

4 Players simulate the next quarter: the costs,revenues, loan demands, and deposit suppliesresulting from their decisions. Each bank com-petes against pre-programmed competitors.

At a pre-announced time, the Administratorsimulates the next quarter: the costs, revenues,loan demands, and deposit supplies resultingfrom Player decisions. Players may not run asimulation in Competitive Games.

5 Begin another cycle: return to Step 2. Begin another cycle: return to Step 2.

Introduction

2

Usually, you will compete in Competitive Mode for a number of simulated quarters. Each period's de-cisions have implications for the future. Prior to at least some simulation periods, your Administratorwill provide a news bulletin or economic forecast containing information that should affect your sub-sequent decisions.

Table 1.1 compares the Autobank and Competitive simulation cycles.

At this point, if you are anxious to starting playing ProBanker, download the Player's QuickStart Guidefrom the player's Main page. (Click the "QuickStart" link on the navigation bar along the screen's leftside.) That Guide provides you the bare essentials for making decisions and simulating your own bank.If you have a bit of patience left, read on...

1.2. Managing a Bank: The BasicsSome of you may already have some feeling for what it means to manage a financial institution. Othersmay have almost no idea at all! Before we go any further, let's level the playing field a bit by providingan overview of the problems associated with managing a banking firm. We'll keep the institution verysimple, and build up the various types of decisions you will need to make in ProBanker.

Table 1.2. Basic Bank Balance Sheet

BabyBank, NA

Assets Liabilities

Loans Deposits

G-Bonds Equity

BabyBank, NA has one generic type of loan and one generic type of deposit. It funds an asset portfoliocomposed of Loans and Government Bonds ("G-Bonds") with Deposits and Equity capital. For now, ig-nore any noninterest operating costs, loan losses, income taxes, or leverage decisions. Just think aboutloan and deposit rates.

More customers will borrow if the loan rate is lower. The bank therefore has an important decision tomake about what loan rate to charge. At a higher loan rate, each dollar lent is more profitable, but notmany people take out loans. At a lower loan rate, each dollar lent returns only a small profit, but manypeople borrow.

Dollars of deposits also respond to interest rates: the bank's rate paid on deposits affects the volume ofdeposit dollars it gathers. Offering a higher deposit rate tends to generate higher deposits (and viceversa, of course).

G-Bonds differ from loans and deposits. Rather than setting an interest rate on bonds, the bank can onlychoose the quantity of bonds to buy. Bonds are available to a bank in perfectly elastic supply. That is,the bond yield remains fixed no matter how many G-Bonds a bank buys. Why do banks purchase G-Bonds? To simplify a bit, the securities (G-Bond) portfolio largely offsets imbalances between the de-mand for bank loans and the volume of deposits supplied to them.

Finally, Equity is the shareholder's capital. Shareholders paid in some capital when the bank was ini-tially formed (or in conjunction with subsequent "seasoned equity issues"), and the bank has retainedsome of its earnings. Equity's claim on bank earnings is the residual -- what is left from loan and bondinterest income, after paying the promised rate to depositors:

• Revenues = Loan interest income + Interest on G-Bonds

• Expenses = Interest paid on deposits

Introduction

3

• Profit = Revenues – Expenses

• Return on Equity (ROE) = Profit / Equity

Management is expected to provide a reasonable (risk-adjusted) return on shareholders' invested equityfunds.

Managers affect profits by choosing what loan rates to charge, and what deposit rates to pay. We can il-lustrate the main idea by considering just two alternative decision sets.

Decision Set "A"

• Choose the loan rate: If RL = 10% then customers will demand $80 of loans.

• Choose the deposit rate: If RD = 6% then customers will supply $105 of deposits.

Decision Set "B"

• Choose the loan rate: If RL = 8% then customers will demand $130 of loans.

• Choose the deposit rate: If RD = 7% then customers will supply $145 of deposits.

Assume that the bank has Equity of $25. Then BabyBank's balance sheet will depend on the decisions itmakes.

Table 1.3. Alternative BabyBank Balance Sheets

If BabyBank Chooses Decision Set "A" If BabyBank Chooses Decision Set "B"

Assets Liabilities OR Assets Liabilities

L = $80 D = $105 L = $130 D = $145

G-Bonds = $50 Equity = $25 G-Bonds = $40 Equity = $25

In each balance sheet, the government bond portfolio serves as the "plug" account: any available fundsthat are not used for customer loans will be invested in a portfolio of G-Bonds. If the government bondrate is 5%, here are the two banks' annual income statements.

Table 1.4. Alternative BabyBank Income Statements

If BabyBank ChoosesDecision Set "A"

If BabyBank ChoosesDecision Set "B"

Interest Revenue OR

From Loans ($80)(10%) = $8.00 ($130)(8%) = $10.40

From Bonds ($50)(5%) = $2.50 ($40)(5%) = $2.00

Interest Expense

On Deposits ($105)(6%) = $6.30 ($145)(7%) = $10.15

Profit $4.20 $2.25

ROE 16.8% 9.00%

Which of these decisions (Set "A" or Set "B") makes the shareholders better off? In other words, whichDecision Set provides the higher ROE?

Introduction

4

It seems clear that shareholders would prefer the BabyBank managers to choose Decision Set "A". Thismakes their bank smaller, but more profitable.

Comparing these two alternative decision sets illustrates some general issues.

• Higher loan rates attract fewer borrowers

• Higher deposit rates attract more depositors

• The size of the Government Bond portfolio adjusts to accommodate the bank's preferred level ofloans and deposits

1.3. Managing a Bank: Some ComplicationsA real bank -- and your ProBanker bank -- operates on these same general principles, but some of the in-stitutional complications make it easy to forget the basics.

1.3.1. From Profits to Market ValueOK. So BabyBank earns $4.20 this year by choosing Decision Set "A." The equity's book value is $25.How much will the bank's equity be worth in the market? A cash flow's valuation depends on the twothings: how much cash is expected each year in the future and the rate at which investors discount thoseexpected cash flows.

Suppose investors expect BabyBank to earn the same $4.20 annually, forever. And suppose that theyfeel 100% sure that profits will be precisely as expected. Then investors should discount BabyBank'sexpected future cash flows at the riskless (G-bond) rate. If the riskless rate of interest is 6%, the value ofthis perpetual cash flow is $4.20/(0.06) = $70.00.

If there are twenty shares of stock outstanding, then, each share is worth $4.20. Notice that a change inthe Government Bond rate of interest will change BabyBank's share price, unless the bank's earningsalso change in the same direction as the interest rates do.

Now introduce uncertainty. Investors are no longer certain that BabyBank will earn $4.20 yearly, al-though that remains their expected cash flow. Now the appropriate discount rate may be higher than thegovernment bond rate -- let's say its 250 basis points above the G-bond rate, or 8.5%. Under this cir-cumstance, the bank will be worth $4.20/(0.085) = $49.41, or $2.47 per share. This calculation showsthat an increase in perceived riskiness can lower a firm's market value. This is why managers are reluct-ant to report widely-fluctuating earnings: it makes investors nervous about future prospects, and theydiscount the firm's expected future cash flows more highly.

What else affects market value? One of the big effects on market value is the rate at which the firm'searnings are expected to grow in the future. So far, we've assumed that the growth rate is zero. By con-trast, let's leave the discount rate at 8.5% and compute the value of BabyBank under the assumption thatits earnings grow 2% per year forever. The bank's market value is now $4.20/(0.085-.02) = $64.615.

Once growth is expected to be 2% annually, BabyBank's share value will fall if profits grow lessquickly, and rise if profits grow faster.

To review: we have identified four things that affect a bank's market value (stock price):

1. The level of expected future cash flows. That is, profits.

2. The growth rate of expected future cash flows. That is, profit growth.

3. The level of riskless interest rates in the economy.

4. Investors' required risk premium (above the riskless rate) for BabyBank's future cash flows.

Introduction

5

Of these four influences, bank managers can control #1 and (maybe) #2 most directly. Via smooth earn-ings and dividend flows, they can also affect #4 -- the discount rate investors apply to BabyBank's earn-ings -- a little bit. Of course, an individual bank's managers have no control over the level of interestrates in their economy.

What does this mean for ProBanker? You need to concentrate on earning high and stable profits, in or-der to provide your shareholders with the best return on their invested capital.

Now we use the bank balance sheet associated with Decision Set A to illustrate some of the finer pointsabout bank profitability.

1.3.2. Operating CostsIn addition to interest earnings and interest expenses, a real bank's income statement has operating costs,or "noninterest expenses." For example:

• Banks pay loan officers to make and monitor loans.

• Banks provide depositors with services in addition to paying explicit interest.

• Buying and selling government bonds generates transaction (brokerage) costs.

Let's approximate operating cost as a constant proportion of the associated dollar balances. Suppose that:

• Loans cost 0.5% per year to make and to manage,

• deposits cost 0.25%, and

• government bonds cost 0.1%.

Further assume that BabyBank continues to set the same loan and deposit rates, even though this wouldprobably not be optimal. Then the previous income statement (see Table 1.4) is now revised to include"Noninterest Expense" as shown in Table 1.5.

Table 1.5. Revised Income Statement, to Include Noninterest Expenses

If BabyBank Chooses DecisionSet "A"

Interest Revenue

From Loans ($80)(10%) = $8.00

From Bonds ($50)(5%) = $2.50

Interest Expense

On Deposits ($105)(6%) = $6.30

Noninterest Expense

Account Costs ($80)(0.5%) + ($105)(0.25%) +($50)(0.1%) = $0.7125

Profit $3.4875

ROE 13.95%

Obviously, higher operating costs reduce profits, and hence BabyBank's share price. Conversely, costsavings raise share price (other things the same). (See ProBanker Economics Lesson: How to MaximizeBank Profits, which you can download from your Help Page at the ProBanker Web site.)

Introduction

6

1.3.3. Loan LossesAlthough Government Bonds are free from default risk, most loans to private parties are not. If thisbank's loans are risky, we over-state its profitability by failing to recognize those possible losses. Sup-pose that 0.3% of all loans do not pay anything back to the bank. Then we'd have an additional line inthe income statement, as shown in Table 1.6.

Table 1.6. Revised Income Statement, to Include Noninterest Expenses and aProvision for Loan Losses


Interest Revenue

From Loans ($80)(10%) = $8.00

From Bonds ($50)(5%) = $2.50

Interest Expense

On Deposits ($105)(6%) = $6.30

Noninterest Expense

Account Costs ($80)(0.5%) + ($105)(0.25%) +($50)(0.1%) = $0.7125

Provision for LoanLosses

($80)(0.3%) = $0.24

Profit $3.2475

ROE 12.99%

1.3.4. Reserve RequirementsBanks generally hold a certain amount of cash (or deposits at other banks) for each dollar of their depos-it balances. Bank supervisors require some of these reserves, but banks also hold some reserves volun-tarily for business reasons. These funds are sometimes called "sterile reserves" because they earn no in-terest. Holding cash reserves reduces the bank's capacity to invest in interest-earning assets. Return tothe balance sheet generated by Decision Set "A" in Table 1.3 and suppose that the bank must hold 4% ofits deposits in the form of cash assets. Then the revised balance sheet would be as it appears inTable 1.7.

Table 1.7. Revised Balance Sheet, to Include Cash Reserves

BabyBank Chooses Decision Set "A"

Assets Liabilities

Cash reserves = ($105)(4%) = $4.20 Deposits = $105

Loans = $80

G-Bonds = $130–$80-$4.20 = $45.80 Equity = $25

Compare the asset side of Table 1.7 to the left half of Table 1.3: bonds have fallen to "make room for"the cash reserves. The associated income statement (Table 1.8) shades the places where reserve-holdinghas affected profits.

Introduction

7

Table 1.8. Revised Income Statement, to Reflect Cash Reserves


Interest Revenue

From Loans ($80)(10%) = $8.00

From Bonds ($50)(5%) = $2.29

Interest Expense

On Deposits ($105)(6%) = $6.30

Noninterest Expense

Account Costs ($80)(0.5%) + ($105)(0.25%) +($50)(0.1%) = $0.7125

Provision for LoanLosses

($80)(0.3%) = $0.24

Profit $3.0375

ROE 12.15%

1.3.5. AdvertisingThe preceding balance sheets and income statements are all based on a fixed demand curve for loans andsupply curve for deposits. The bank's marketing department tries to shift these curves so the bank can at-tract a greater volume of loans at any given loan rate charged and a greater volume of deposits at anygiven deposit rate offered.

Let's return now to the very simplest case, before we introduced operating costs, loan losses, or reserverequirements. The balance sheet on the left in Table 1.9 is just copied from the very first one presentedabove. On the right, we assume that an advertising campaign can generate more deposit and loan busi-ness at the same interest rates.

Table 1.9. Effect of Advertising on Balance Sheet in Table 1.3, Given Decision Set"A"

Decision Set "A" WITHOUT advertising Decision Set "A" WITH advertising

Assets Liabilities OR Assets Liabilities

L = $80 D = $105 L = $120 D = $125

G-Bonds = $50 Equity = $25 G-Bonds = $30 Equity = $25

Will advertising make the shareholders better off? Table 1.10 displays the bank's two pro forma annualincome statements.

If advertising were free, the bank would clearly prefer to advertise: its shareholders would earn $6.00per year instead of $4.20. But, of course, there's no free lunch. Advertising must be paid for. What is thelargest budget BabyBank should provide to its Marketing Department? The effect of advertising onProfit is $1.80, so any expenditure up to this amount improves the bank's profitability (assuming that ad-vertising has no effects beyond this one time period).

In ProBanker, as in this simple example, advertising and account interest rates complement one another.As a bank CEO, you can attract new loan customers by charging a lower rate or through more market-ing. Similarly, you can attract more deposit customers by raising the deposit rate or by advertising. The

Introduction

8

key to profitability is finding the combination of these two tools that produces the greatest net benefit foryour shareholders.

Table 1.10. Effect of Advertising on Income Statement, Given Decision Set "A"(compare to Table 1.4)

Decision Set "A"WITHOUT advert-

ising

Decision Set "A"WITH advertising

Interest Revenue OR

From Loans ($80)(10%) = $8.00 ($120)(10%) = $12.00

From Bonds ($50)(5%) = $2.50 ($30)(5%) = $1.50

Interest Expense

On Deposits ($105)(6%) = $6.30 ($125)(6%) = $7.50

Profit $4.20 $6.00 – Ad Cost

1.4. How to Use This ManualAfter you register on the ProBanker website you will have access to this manual. It is available onlinewithin your account, via the [Help] button on your menu bar. Registered users can also download a PDFversion of this manual, again available as an option after you click the [Help] button from within yourProBanker account. As described in Section 2.8, that version can be printed or read/searched on thescreen, using the (free) Acrobat Reader™, which can be downloaded from www.adobe.com[http://www.adobe.com/products/acrobat/readstep.html].

The remainder of this manual has five chapters and two appendices. First, we tell you how to interactwith the ProBanker program. Chapter 2 explains how to

• access the software

• generate reports about your bank's condition and the broader economic environment,

• export this report information to other program applications.

• "turn back the clock" in Autobank Mode, and

• submit your quarterly decisions in Competitive Mode.

The next two chapters explain the economic and financial features of your ProBanker financial institu-tion. Chapter 3 provides an overview, and then Chapter 4 describes in detail how each account behaves.Chapter 5 then explains how your quarterly managerial decisions affect bank profits and market value.

Chapter 6 presents a set of analytical tools and tips, which should help you understand how to enhanceyour shareholders' wealth. Appendix A summarizes and re-presents some of ProBanker's most import-ant concepts and issues, in the form of Frequently Asked Questions (FAQs). Appendix A presents nonew information, but rather organizes the same information a bit differently. We hope this presentationcomplements the understanding you gain from reading the other chapters. Finally, Appendix B providesa set of sample reports for you to peruse.

Even though the ProBanker simulation environment is considerably simpler than a real bank, it is still acomplex, inter-related financial system. You should not expect to comprehend it fully after reading thismanual only once. Rather, you will find it best (and, in the long run, easiest) to read through the manualonce quickly, and then play Autobank for a while. As you work your way through the menus and de-cisions offered by Autobank, make a list of the things that puzzle you. Then return to the Player's Manu-

Introduction

9

http://www.adobe.com/products/acrobat/readstep.html

al for another reading.

Please(!) resist the temptation to "pick up what I need to know as I go along." You must be quite famili-ar with how ProBanker works before you can really learn much from your simulation experience. YourProBanker efforts should be "front-end loaded": as simulation periods pass by, you will be understand-ing more and more, in less and less time. Rest assured, however, that you will continue to find newthings to learn even after many simulated periods.

Finally, a word about computer literacy. The ProBanker interface should be accessible even to peoplewith limited experience with Internet applications. Operating ProBanker therefore requires only minimalcomputer skills. However, your ability to analyze performance and to write cogent reports about yourmanagerial experience will be enhanced if you utilize ProBanker's ability to export output files to aspreadsheet or word-processing program.

The ProBanker simulation poses serious financial problems for you to solve -- but it is also supposed tobe fun. Good luck!

Introduction

10

Chapter 2. Operating the PlayerSoftware

ProBanker is played entirely over the Internet, using a standard browser. You don't need to install anyspecial software on your computer, and you can access ProBanker and your bank's records anytime,from any place in the world. ProBanker has tested successfully with Internet Explorer™ (ver. 4.0 andabove), Netscape™ (ver. 4.0 and above), Opera™ (ver. 6.01 and above), and Mozilla™ (ver. 1.1 andabove). Although all these browsers work fine, we have found that early (ver. 4.x) versions of Netscapetend to load some of the web pages more slowly than the others.

2.1. Registering to Use ProbankerWhen you first connect to www.probanker.com [http://www.probanker.com] you will be offered severalchoices:

If you are reading this manual, you no longer need the Tour. So choose [Log In], which leads to:

Your Administrator should have provided you with an initial Name and Password. (Don't spend a lot of

11

http://www.probanker.com

time memorizing these, since you'll be able to change both of them shortly.) Enter these two words inthe appropriate places and click [Log In].

After successfully logging in, you will probably come to "Paying for ProBanker," where you have fouralternatives:

Initially, you will be provided with a few free logins. Clicking that radio button and [Continue] movesyou directly into playing the game.

Eventually, you will need to pay for the right to use ProBanker in your course, and this payment can bemade either online (via credit card) or by mail (via a check or money-order). If you pay early, you'll beentered in your Administrator's database sooner, and you can change your login information tosomething more personal. We also have a liberal Refund Policy:

Refund Policy

ProBanker will refund your payment in full if you withdraw from your current course. To re-quest a refund: (a) send a message to [email protected][mailto:[email protected]] stating that you have dropped the course; and (b) be sure toprovide your ProBanker UserID and a current mailing address in your e-mail. After confirmingyour withdrawal status, we will mail you a check for your original payment amount. It's thatsimple!

A "Free Login" login provides you limited access to ProBanker's features: you may download a Quick-Start Guide to get you oriented, and you can create and manage Autobanks. Once you have paid, ofcourse, all ProBanker features become available to you.

2.2. Changing Your ProfileProBanker stores a bit of information about you, so your Administrator can identify your bank cor-rectly. To see (and to revise) this information, click [Your Profile] on the left-hand part of your MainPage:

Operating the Player Software

12

mailto:[email protected]

This link takes you to an information-gathering screen:

The most important item to enter here is your name, which identifies you to the Administrator when sheor he is assigning banks, recording assignments, and so forth. Some Administrators may also ask foryour Student ID number, but this is optional. (If you are playing as a team, your Administrator may sug-gest how to name yourselves.)

To change your initial Username and Password to something more meaningful to you:

1. Enter the new Username you would like to use into the box labeled (surprise!) "Username." Prob-ably, you can have the one you request, but if another player has already taken that name you willbe asked to choose a different one. (Note that your Username cannot be the same as any otherplayer's in the ProBanker database. These players extend far beyond your course.)

2. Enter the new Password you would like to use, then enter your new Password again as confirma-tion.


13

3. Finally, enter your initial password where it asks for "Current Password", and click [Change MyProfile].

It's also very useful (to us and to your Administrator) for you to enter an email address, in case we needto contact you on short notice.

2.3. Playing GamesAfter you have paid for ProBanker, logging in takes you directly to the Player's Main Page:

Note the three tabs at the top of this page: "Competitive Games," "Autobank Games" and "Templates."Your administrator controls what you see on the Competitive and Template pages. You can initiate yourown Autobank games from the Templates provided to you.

The "Competitive Game" tab above shows that you are playing in a game called "Official 6905 BankGame." The bank shown with the "clicked" radio button -- Flannery Bank and Trust -- is the one youhave been assigned to manage. Click [Play Game] and you will be taken to this screen:

From here, you can enter decisions, save them (see the button at the very bottom of this page on yourcomputer screen), and see reports. We'll return to Reports in Section 2.4 and Section 2.5, and to decisionentry in Section 2.6, below.

Now go back to the Main Player's Page and click the Templates tab:


14

A Template is sort of a bank in "cold storage," which you can convert into an Autobank Game. To makean active Autobank Game for yourself, start with one of the Templates your Administrator has madeavailable on this page:

1. Select your desired Template by clicking its radio button.

2. Then click on [Create New From...].

3. Name your new Autobank:

4. Click on [Create Autobank].

After creating a new game, your "Autobank Games" tab will list all the games you have available toplay:

Select a Game's radio button, click on [Play Game], and you will be transferred to the "Game De-


15

cisions"/"Reports" page:

Before making decisions, you should examine some Reports about your bank's current condition.

2.4. Generating ReportsReports describe your bank's current financial condition. Use this information as the basis for your de-cisions in the subsequent quarter. When you first initialize a Game, the reports will describe your bank'scondition at the end of "Quarter 0". Your first decisions will affect the bank's performance in Quarter 1.Sample reports are presented in Appendix B, and individual reports are discussed further in Chapter 3and Chapter 4. For the moment, we'll concentrate on the mechanics of manipulating ProBanker's reportwindows. Click on the [Reports] tab to see the list of available reports:


16

(Not all ProBanker implementations provide the same set of reports. Once again, your Administrator canmake some choices, and your Reports page lists only the reports available to players in your economy.)

Generate a specific report by highlighting its radio button and clicking [View Report]. The report ap-pears in a new Window, from which it can be printed using your browser's "Print" button, or saved to adisk file in HTML format. You can generate reports about any quarter up to the present one (Quarter 0 isselected in the screen shot). You can also generate a single report for all quarters up to the present: usethe pull-down "Select Quarter" menu to highlight "All".

2.5. Downloading Bank Data to a SpreadsheetIn addition to printing individual reports for specific quarters, you can download all of your bank's his-torical data to a file that Excel™ and other spreadsheet programs will read easily. This format is called"comma-separated values" or CSV. On the "Reports" tab, select the [Download CSV] button at the bot-tom of this screen to dump your bank's history. The format of these CSV reports is not quite the same asthe formats of the reports produced by ProBanker's "Reports" tab, but they are similar and each row hasa descriptive label.

If you are good with spreadsheets -- or if you need to be good -- you can use these data to analyze yourbank's condition at any point in time, or its trends over time. Your Administrator may also provide youwith a spreadsheet that produces reports very much like the ones produced for each single period on the"Reports" tab.

2.6. Entering DecisionsTo input your decisions for the coming quarter, click on [Play Game] in the Player Main Page, to get:

When you are first presented with the "Game Decisions" form, its boxes contain the decisions' valuefrom the preceding quarter. (So you don't need to re-enter the decisions you don't want to change.) Eachdecision variable's description appears in the left-most column, and the range of permissible values isprovided just to the right of the entry boxes for the "Upcoming" quarter's decisions. (You can enter a de-cision outside the permissible range, but ProBanker will not save out-of-range decisions. You must inputacceptable values in order to save your decisions and proceed.) The last few columns show the decisionsmade for previous quarters (only Q0 in the case shown here).

When entering decisions, be sure to observe two simple ProBanker conventions:


17

• All dollar quantities in ProBanker are measured in thousands. (Many real-world banks follow thesame convention in their financial statements.) For example, if you purchase "25000" new bonds,you are asking for $25 million worth. An advertising expenditure of "450" means $450,000 perquarter-year. Be careful to specify your dollar magnitudes in thousands of dollars.

• Interest rates must be entered in "percent." That is, enter 10% as 10.0 (or just 10). Enter "one-halfpercent" as 0.50.

Table 2.1 provides some further information about entering your decisions accurately.

Finally, don't forget to save your decisions after you have entered them! The decisions in your bank'sdata files remain unchanged until you explicitly save a new set of decision values. To save your de-cisions for the coming quarter, click on the [Save Changes] button located at the very bottom of the"Game Decisions" tab. You can print your current or historical decisions via your web browser's [Print]button.

Table 2.1. Summary Information about Entering Decisions

Description Affected Decisions

Dollar Amounts

Decisions # 1 through # 14 are entered in thousands ofdollars. So if you wish to issue $100 million of new,360-day CDs, enter 100,000.

1. Initial Reserve Allocation2. Federal Funds Sold3. Federal Funds Purchased4. 90-day CDs to issue5. 180-day CDs to issue6. 360-day CDs to issue7. New 8-Quarter Bonds to Purchase8. Bonds to sell, due start of T+29. Bonds to sell, due start of T+310. Bonds to sell, due start of T+411. Bonds to sell, due start of T+512. Bonds to sell, due start of T+613. Bonds to sell, due start of T+714. Bonds to sell, due start of T+8

Rates

Decisions #15 – #23 are the interest rates you chargeon loans or pay on deposits. Enter 7½% as 7.5. (YourAdministrator may limit the deposit rates you may set-- see the Economic Environment Report for currentinformation.)

15. Fixed rate Corporate Loans16. Floating Rate Loan Spread17. Installment Loans18. Mortgage Loans19. Retail CDs20. Passbook Savings21. IRAs22. Retail Demand Deposits23. Corporate Demand Deposits

Advertising

Decisions #24 - #30 are the quarterly advertisingbudgets you wish to direct at each of the indicated ac-count types. Remember (again) that the decisions areexpressed in thousand dollars. So enter "fifty thou-sand" as 50.

24. Ads, Installment Loans25. Ads, Mortgage Loans26. Ads, Retail Demand Deposits27. Ads, Corporate Demand Deposits28. Ads, Retail CDs29. Ads, Passbook Savings30. Ads, IRAs

Share Sales

Adjust your equity capital account by issuing newshares (enter a positive number here), or repurchasing

31. Number of Shares to sell


18

Description Affected Decisions

shares from the market (enter a negative number here).

Provision for Loan Losses (PLL)

The amount, in thousand dollars, that you wish to addto your bank's Loan Loss Allowance account. Thisentry reduces your reported net income.

32. Provision for Loan losses

Corporate Loan Standard (CLS)

In making Fixed Rate and Floating Rate corporateloans, you can choose to have a high credit standard(indicated by a decision of +1), an average standard(decision of 0), or a low credit standard (-1).

33. Corporate Loan Standard

Dividends

The value, in thousands of dollars, of dividends youwish to pay to all outstanding shares. (This is not a di-vidend per share.)

34. Total Dividends

Demand Deposit Fees

You can charge your demand deposit customers feesfor payment services. These fees are expressed here asa percentage of your costs of providing the services.Express these two percentage amounts the same wayas you expressed loan and deposit rates above: "onehundred percent" = 100.

35. % of Cost charged to Retail DD36. % of Cost charged to Corporate DD

2.7. Using Autobank to Learn About ProBankerSometimes, you will find it convenient to "re-run history" in Autobank Mode. Maybe you made someterrible decisions and want a fresh start. Alternatively, you might want to simulate alternative loan pri-cing decisions over the same series of government bond rates. Turn back the Autobank quarter indicatorby clicking [Back 1 Quarter] at the bottom of the "Game Decisions" tab. You can go back as many quar-ters as you like, by repeatedly choosing [Back 1 Quarter].

What if you back up too far? No problem! Since your entire decisions history is permanently stored, se-lecting [Simulate] at the bottom of the "Game Decisions" tab will replicate whatever initially happenedin that quarter. If you wish to go all the way back to your initial condition (at Quarter 0), you can eitherrepeatedly move back one quarter at a time, or you can go the Template tab on your Main page and cre-ate a new game from [Create New From...] the same template you started with.

Caution

You may be tempted to try using Autobank to "check out" the effects of Competitive decisions.Don't bother. This technique fails to give representative results, because your "real" competitorsare unlikely to behave the same way as Autobank's pre-programmed competitors do. So don'ttry to flip back and forth between Autobank and Competitive Games, hoping to learn what willhappen in the Competitive environment from an Autobank simulation. Use Autobank to learnabout ProBanker, then switch over to the Competitive environment permanently.

2.8. Help


19

You can view ProBanker's Player Manual online, or download it (in pdf format) by selecting [Help] onthe Player's Home Page, which opens a new browser instance displaying:

Whenever you are connected to the ProBanker site, the [Help] button on the Player Main Page brings upthis table of contents for the Player's Manual. Within this help browser, the menu bar on the left-handside guides you through several documentation options. First, you can download a printable (.pdf) ver-sion of the manual (zipped) by clicking on the "Entire Manual" link. By saving the entire Player's Manu-al on your hard drive, you can read and search it with the (free) Adobe Acrobat Reader™, even whenyou are not connected to the Internet. (If you don't already have a copy of the Acrobat Reader, you candownload it from Adobe [http://www.adobe.com/products/acrobat/readstep.html]). This version of thePlayer's Manual is has hot links in the table of contents, so you can jump to a specific chapter or section.You can also use the Adobe Reader's Search feature to find the specific information you need. Finally,you can print a copy of the Manual.

Second, the menu bar offers a list of bullet points, corresponding to the chapters and appendices of thePlayer Manual. Click on any one of these links in the menu bar, and the corresponding chapter of themanual will load into the right-hand browser panel. Each chapter has its own table of chapter contents,in addition to the overall table of contents in the first section. Pointer buttons at the top and bottom ofeach page link forward and backward to the next and previous pages. Additionally, links appear at thebottom center of each page, which connect to the start of the chapter (up pointer) and the start of themanual (the home pointer).

Lastly, some "extra" lessons on special topics are available via the links at the bottom of the menu bar.These are printable (.pdf) files on advanced topics, for further study.


20

http://www.adobe.com/products/acrobat/readstep.html

Chapter 3. ProBanker's FinancialStructure (Overview)

The basic management issues described in Section 1.2 and Section 1.3 also apply to your ProBankerbank, but now you need to manage a variety of deposit and loan accounts (not just one of each).

Your board of directors expects you to maximize the return to your initial shareholders. To do this, youmust maximize the market value of your equity, which requires that you produce high and stable profits.(Section 4.10 describes additional influences on the welfare of your initial shareholders.) Your profitsare determined by the relation between your pricing and other decisions and your rivals' decisions.

Every quarter, you set loan rates, deposit rates, and advertising budgets for multiple loan and deposit ac-counts. You issue wholesale liabilities, deal in the short-term interbank market, and trade governmentbonds, while making sure that your sources of funds at least equal your uses. You pay dividends and sell(or retire) shares to control the bank's capital ratio. Your goal: to make high profits and boost yourbank's stock price.

This Chapter presents a broad overview of ProBanker's financial features. Chapter 4 provides the struc-tural details you need to make really good managerial decisions.

3.1. The Balance SheetBefore plunging into the details, we should explain two basic types of ProBanker balance sheet items:Rate-Set Items and Quantity-Set Items. Each asset or liability has one of these features or the other.

Managers select the interest rate to pay on Rate-Set deposits or to charge on Rate-Set loans. Customersthen compare this rate with the terms being offered by other banks in the Region, and decide which bankto deal with. A bank with relatively attractive rates gets more than its proportional share of the Region'sbusiness, but far from all.

No single bank's managers can affect the interest rate on Quantity-Set Items, which are also called "per-fect market" assets or liabilities. For these balance sheet categories, you take the associated interest rateas given, and simply specify the dollar amount you wish to have.

Quantity-Set Items

A security is said to trade in a "perfect market" when individual buyers and sellers can tradelarge quantities without having a noticeable effect on the security's price. Perfect-market secur-ities must be available in large supply, and have very low default risk -- or at least have defaultprobabilities that are widely understood. A financial institution will buy and sell perfect marketsecurities to fill gaps in its balance sheet, or as a means of speculating on interest rate changes.ProBanker's Quantity-Set assets and liabilities trade in perfect markets.

You can obtain a "Full Balance Sheet Report," which provides details about your own bank and someinformation about your rivals' situations. For many purposes, you need the details contained in a FullBalance Sheet Report. For now, however, we can get by with fewer details. We use the "Summary Bal-ance Sheet" presented in Table 3.1 to explain your bank's various assets and liabilities.

Line 1 records your bank's required (non interest-earning) cash reserves at the Federal Reserve (the cent-ral bank). These reserve balances must satisfy reserve requirements, which are expressed as a proportionof various deposit balances. The Economic Environment Report always shows the current reserve re-quirement rates (see Appendix B). Since these requirements can change during the course of your simu-

21

lations, be sure to monitor them each quarter.

Line 2 reports your bank's Excess Reserves -- cash balances you hold with other banks primarily as away of facilitating the payment services you provide to your customers. Bank supervisors set no minim-um requirements for these balances.

Table 3.1. Summary Balance Sheet

Bank: NewWorld Bancorp, Ltd.

Player: Derwood Kirby

Summary Balance Sheet Report: Quarter 0

ASSETS

1. Required Reserves (at the Federal Reserve) 30,515.70

2. Excess Reserve Balances (at other commercial banks) 0.00

3. Federal Funds Sold 0.00

4. Fixed Rate Corporate Loans 152,071.49

5. Floating Rate Corporate Loans 435,717.24

6. Installment Loans 350,612.89

7. Mortgages 425,548.94

8. Bonds 180,000.00

9. Fixed Assets 21,739.00

10. Loan Loss Allowance 5,302.78

11. Total Assets 1,596,205.25

LIABILITIES

12. Federal Funds Purchased 35,000.00

13. Retail Demand Deposits 158,633.21

14. Corporate Demand Deposits 146,523.78

15. Negotiable CDs 200,000.00

16. Passbook Deposits 86,714.41

17. Retail CDs 326,304.90

18. IRAs 327,278.51

19. Discount Window Advances 192,847.07

20. Net Worth and Retained Earnings 327,278.51

21. Total Liabilities and Net Worth 1,596,205.25

The third line reports Federal Funds Sold (FFS), which are short-term, unsecured loans you made to oth-er banks. Although FFS are usually overnight loans, ProBanker reports the daily average position yourbank maintained during the preceding calendar quarter.

Federal funds

Fed funds are short-term (usually overnight), unsecured loans between banks. Sellers (lenders)use Fed funds as a marginal interest-earning investment. Fed fund purchasers (borrowers) usethis source of funds to finance their asset portfolios. A lender of Federal Funds carries an assetitem called Federal Funds Sold. The borrower shows a liability item, Federal Funds Purchased.

ProBanker's Financial Structure (Overview)

22

The next four lines in Table 3.1 (#4 through #7) describe ProBanker's "Rate-Set Loans." You select acontract interest rate to charge on each loan type, but the volume of loans your bank extends will dependon how attractive customers find your chosen rates to be.

Lines 4 and 5 identify two sorts of loans to corporations: Fixed Rate loans (FR) mature in one quarter,and you specify a exact rate of interest paid on new Fixed Rate loans. Floating Rate loans (FL) mature intwo quarters. The ProBanker macroeconomic environment determines a "floating loan base rate" andeach bank chooses a "spread" or premium over this rate. The borrower's cost of funds is thus the sum ofthe base rate and the spread you charge. (For example, suppose the Floating Rate Loan Base is 5.75%. Ifyou charge a Floating Rate spread of 2%, then your borrowers would pay interest at a rate of 7.75% peryear. This contract rate changes when the Floating Rate Loan Base changes -- usually quarterly.)

Lines 6 and 7 describe your retail (consumer) loans, which take the form of four-period installmentloans (INST) and eight-period home mortgages (MORT).

For each loan type, the volume of business you attract varies inversely with the interest rate you charge.If you demand a high loan rate, some customers will go to cheaper rivals or do without a loan. If youlower your loan rate, you will attract some of these customers back, along with some of your competit-ors' former borrowers. You can also advertise to attract INST and MORT loan customers: holding theloan rate constant, greater advertising increases your loan account balances.

Line 8 in Table 3.1 indicates that you may choose to hold government bonds, which are available in per-fectly elastic supply. Each quarter, market supply and demand factors affect the yields on each outstand-ing bond. You may purchase new (eight-period) bonds at par and sell old bonds out of your investmentportfolio at current market prices. Information about your bank's investment portfolio is described in aquarterly Bond Portfolio Report. (See Appendix B for a sample, or generate one for yourself using Auto-bank.)

Line 9 lists your banks' Fixed Assets, which are mostly comprised of plant and equipment. You cannotaffect this dimension of your bank's size. Depreciation of these fixed assets is recognized as an expensein the income statement each quarter.

Line 10 lists a contra-asset account -- the loan loss allowance (LLA). You need to manage this accountin accordance with your loan portfolio's anticipated credit losses and some simple government regula-tions (described in Section 4.6).

Now turn to the liability side of the balance sheet, which starts in line 12 of Table 3.1 with FederalFunds Purchased (FFP) -- overnight loans obtained by your bank in the interbank market. FFP is a"Quantity-Set Item." Use FFP as a source of wholesale funding. (As with FFS, ProBanker assumes thatyou roll over your desired quantity of overnight FFP each business day during the calendar quarter.)

Caution

If your bank becomes too highly levered, uninsured lenders (FFP, Negotiable CDs) demand ahigher interest rate to cover perceived default risk. Very highly levered banks will be unable toobtain all the funds they request in these markets. (See Section 4.8.)

Lines 13 and 14 indicate that your bank offers demand deposit ("checking") accounts to both retail cus-tomers (called DDR) and to large corporations (DDC). Your Administrator may sometimes set regula-tions forbidding banks from paying explicit interest on demand deposit balances (check the EconomicEnvironment Report). Competition for these accounts then takes the form of advertising or low pricescharged on the transaction services you provide to demand depositors.

Your bank offers three types of retail time deposits: Passbook Deposits (line 16, no explicit maturity),Retail CDs (line 17, 2-period maturity) and IRAs (line 18, 8-period maturity). Each quarter, you choosea separate interest rate and advertising budget for each of these accounts. New balances earn this new


23

rate, while the rates paid in past periods continue to apply to outstanding Retail CDs and IRAs. A higherdeposit rate (or more advertising) causes more customers to maintain an account at your bank.

The Discount Window (line 19) is ProBanker's ultimate source of loanable funds. Although you haveadequate sources for obtaining loanable funds, no one can know if your balance sheet balances untilyour decisions are combined with those of your competitors. If you end up promising more loans thanyou can fund on your own, the Discount Window lends you the difference -- but at a pretty steep penaltyrate. (This rate premium is set by your instructor.) Your bank will be more profitable if you can avoidDiscount Window Advances (DWA).

Table 3.2 reviews the preceding information by summarizing the specific decisions you make aboutProBanker assets and liabilities. The numbers in Table 3.2 correspond to the balance sheet line numbersin Table 3.1.

Table 3.2. ProBanker Account Characteristics

What do I decide? Can I advertise?Maturity (in

quarters)

* You enter a decision at the start of the quarter, but ProBanker may change some of these ac-count balances when balancing the balance sheet or fulfilling reserve requirements. (See Sec-tion 4.11.)

** Regulations may permit payment of explicit interest on demand deposit accounts. See theEconomic Environment Report each quarter.

*** Demand deposits can be withdrawn at any time -- "on demand." But most people operatewith positive balances in their demand deposit (checking) accounts for long periods of time.So what is the effective maturity of a demand deposit? Passbook account balances behavesimilarly.

1 Required Reserves Quantity * No 1

2 Excess Reserves Quantity * No 1

3 Federal Funds Sold Quantity * No 1

4 Fixed Rate Corp. Loans Rate No 1

5 Floating Rate Corp. Loans Rate spread No 2

6 Installment Loans Rate Yes 4

7 Mortgage Loans Rate Yes 8

8 Bonds Quantity No 8

12 Federal Funds Purchased Quantity * No 1

13 Retail Demand Deposits Rate, fees ** Yes ***

14 Corporate Demand Deposits Rate, fees ** Yes ***

15 Negotiable CDs Quantity No 1, 2, 4

16 Passbook Rate Yes ***

17 Retail CDs Rate Yes 2

18 IRAs Rate Yes 8

3.2. The Income StatementProBanker produces the fully detailed, quarterly Income and Expense Report shown in Appendix B.However, we can explain the main issues using the stylized Income and Expense Report in Table 3.3.

Line 1 of Table 3.3 presents Fee Income, which is generated in ProBanker exclusively as demand depos-


24

it service charges. We discuss the effects of demand deposit fees in section 4.5.12.

Table 3.3. A Stylized Version of ProBanker's Income and Expense Report


Income and Expense Report

REVENUES

1. Fee income 1,673.23

2. Interest income 45,243.24

3. Short term capital gains (loss) on bonds 155.00

4. Total Revenue 47,071.47

EXPENSES

5. Interest expense 22,511.06

6. Operating expenses 17,801.10

7. Advertising 4,550.00

8. Provision for Loan Losses 2,037.36

9. Total Expenses 46,899.52

10. Net Current Operating Earnings 171.95

11. Taxes on current earnings 60.18

12. Realized capital gains 2,345.00

13. Capital gains tax 469.00

14. Net Income 1,987.77

Line 2 reports the sum of all interest income earned from loans and bonds. Short-term capital gains(losses) appear in line 3, reflecting gains or losses realized from the sale of bonds that were held in yourportfolio for only a short period of time. The sum of these three broad income components is Total Rev-enue in line 4.

Expenses include interest paid on deposits and other liabilities (line 5) and advertising (line 7), which wehave discussed previously. Line 6 reports the bank's noninterest operating expenses -- salaries, rent, util-ities, and so forth. In this case, operating expenses are nearly as large as interest paid! When setting loanor deposit rates, you need to take account of the operational expenses associated with these accounts. Ifyour loan rate is 11%, for example, but associated operating expenses consumer constitute 2.5% of out-standing loan balances, then your net loan income is only 8.5%, not 11%. We'll give you further detailsabout how to treat operating expenses in Chapter 4. For now, just realize that it can be an importantcomponent of your costs.

Line 8 reports the Provision for Loan Losses -- management's best estimate of changes in the loan port-folio's likely losses since last quarter. Remember from Section 1.3 that you would overstate your incomeby failing to recognize these losses at the time new loans are made. ProBanker loan losses depend onyour loan portfolio's composition (e.g. retail installment loans generally suffer larger losses than corpor-ate loans do), your corporate loan underwriting standards, and macroeconomic conditions. Each quarteryou must make a new provision for loan losses. (See Section 4.6)

The difference between Total Revenue (line 4) and Total Expenses (line 9) is Net Current OperatingEarnings (NCOE) in line 10. These are the earnings from a bank's "normal" operation, and the implica-tion is that outsiders can expect the bank to continue operating at this level of profitability. Taxes (line11) are paid on NCOE at the usual corporate tax rate reported each quarter in the Economic Environ-ment Report.

Line 12 reports that this bank sold some investments (government bonds) at a profit of $2,345, which


25

qualifies for tax treatment as "long term capital gains." The tax rate on long-term gains (reflected in line13) is often lower than the rate on regular earnings (see the applicable tax rates in the final section of theEconomic Environment Report).

Finally, we arrive at the bank's "bottom line," Net Income for the quarter (line 14).

A Caution about Taxes

ProBanker’s tax system is simpler than the current U.S. tax code. Specifically, ProBanker hasno provision for tax loss carryforwards or carrybacks. This means that if your bank runs a loss,the income statement will show the associated taxes, but that entry does not influence your NetIncome.

3.3. CEO Decisions and ProBanker's Timing Con-vention

The 36 individual decisions you make each quarter fall into several groups:

• Quantities of "perfect market" assets to buy and liabilities to issue,

• Interest Rates on Rate-Set loan and deposit products,

• Advertising expenditures,

• Capital structure decisions (issue/retire shares, pay dividends)

• Miscellaneous other decisions.

You are making your new decisions before the start of the calendar quarter to which they will apply.(Think of yourself making new decisions late on September 30, to apply to all the new business doneduring the period October 1 – December 31.) Because ProBanker undertakes numerous accountingchores around the turn of each quarter, it is important to understand how the balance sheet and incomestatement reports relate to one another, and to the passage of calendar time.

Figure 3.1 illustrates where your quarterly decisions fit into ProBanker's timing.

Figure 3.1. Event Timing in ProBanker

Suppose Quarter T has just been simulated and you obtain the end-of-Quarter-T Balance Sheet. Theseasset and liability positions describe the very last instant of that quarter. Likewise, the Income statementincludes all accrued expenses and revenues, and net income has been posted to the equity account.

All cash flows in ProBanker occur on the first day of the simulated quarter. The following are particu-larly important to note:

• Maturing deposits are paid off.


26

• Maturing loans and bonds are paid off.

• Losses occur on some of the maturing loans.

• Dividends (perhaps zero) are paid out of New Worth, resulting in a new bank capital level for thecoming quarter.

These imminent cash flows affect how your interpret your balance sheet from the "End of Quarter T."Any balance shown as "maturing at the start of Quarter T+1" will be paid at the very first instant of thatquarter. You must therefore make decisions with that in mind. For example, if you have a large stock ofFed Funds Sold and Negotiable CDs maturing at the start of Quarter T+1, you need to make decisionsthat will replace those liabilities now ("between quarters" in Figure 3.1).

The income statement from the "End of Quarter T" shows the revenue and expenses accrued during thequarter, and has posted the resulting Net Income to the Net Worth account.


27

Chapter 4. ProBanker's FinancialStructure (Details)

With Chapter 3's overview as background, you are now ready to delve into the details about howProBanker sets loan and deposit balances, how to assure that you have sufficient loanable funds to honoryour commitments, and so on. This chapter presents detailed information about financial structure, thatis vital to making proper decisions at each stage in the ProBanker simulation.

4.1. General Account FeaturesBefore presenting the detailed characteristics of each asset and liability account, we should point out afew general account features.

• Each account has a stated maturity. As we will see in Section 6.3, however, customer relationshipssometimes make effective maturities longer than stated maturities.

• All loans, deposits and bonds in ProBanker are balloon instruments: interest is paid at the end ofeach quarter, but no principal is repaid before maturity. This feature makes the maturity and the dur-ation of loans and bonds nearly identical.

• Bonds can be sold in a secondary market prior to their maturity at current market prices.

• All other assets and liabilities must be held to their stated maturity. Even ProBanker's mortgageloans never prepay early.

• CEOs control accounts either by choosing contract rates ("Rate-Set Items") or by specifying the dol-lar quantity they wish to buy or sell ("Quantity-Set Items").

• Some loan and deposit accounts respond to marketing campaigns. Think of Advertising expendituresas a portmanteau variable which includes marketing expenditures, branch operating costs, free gifts,subsidized ATM transactions, etc. -- anything that benefits customers but is not an explicit cash pay-ment. Advertising is thus a form of implicit interest payment, which complements pure price com-petition as a means of attracting new loan and deposit business.

• Banking services cannot be produced without using labor, physical capital, and materials. ProBankerreports the operating costs associated with each type of account in its quarterly income statement.While a few balance sheet items have zero operating costs, most require some noninterest expendit-ure. Section 4.3 and Section 4.4 explain how these operating costs are determined.

Advertising

You may wonder why a bank would prefer to attract customers with advertising instead ofsimply paying a higher deposit rate or cutting its contract loan rate. The situation for banks isnot unusual: why does Domino's Pizza advertise, instead of trying to attract customers with justa low price? In ProBanker, there are two reasons to advertise. First, banks were historically lim-ited (by Regulation Q) in their ability to pay market rates on some types of deposits. In place ofexplicit interest, they competed by offering convenient offices and long banking hours, freegifts, etc. In the United States, Reg Q was mostly eliminated by 1986. Now only demand de-posits (may) retain a deposit rate ceiling.

Second, banks advertise because some implicit compensations may be more valuable to cus-tomers than the same expenditure on explicit interest would be. In ProBanker, customers al-ways respond to higher advertising expenditures, although at a diminishing rate. For sometypes of accounts and over a limited range, advertising may be more highly valued than explicitinterest (which is taxable to the recipient).

28

We start by describing how the dollar volumes are determined for your Rate-Set Items.

4.2. Determining the Quantity of Rate-Set ItemsTable 3.2 indicates nine account types for which the CEO chooses an explicit contract rate each quarter.The volume of balances generated by the rate you set is determined in two steps.

In the long run, the only thing that affects Rate-Set account balances is the effective rate charged (paid)by your bank relative to the rates charged (paid) by your competitors and the rates available in theprimary market.

Competition from the Primary Market

Each bank's most direct competition comes from other banks in the same competitive Region.However, customers living in the Region are not required to bank with a local bank. Supposeall the bankers in a Region conspired to set their deposit rates very low. Some customers wouldshop for better rates in other geographic regions, or by looking for primary market investmentslike treasury bills or money market mutual funds. Borrowers would behave the same way. IfRegional banks offered a good deal, they'd bank locally. But if all Regional loan rates werehigh, some potential borrowers would seek loans from distant banks or their suppliers. Otherscould issue commercial paper (at rates determined in the financial market), or liquidate someinvestments.

ProBanker models these effects for Rate-Set Items by comparing each bank's effective rate tothe government bond rates currently available in the economy.

Even though relative prices are all that matter in the long run, many bank customers respond slowly(incompletely) to price changes. Some accounts involve "customer relationship" or "reputation" ele-ments, which are particularly important in retail and small business products. Once a particular customerhas established her relationship with a bank, she does not move that account in response to minorchanges in competitive conditions. ProBanker captures this phenomenon in the form of slow (partial)adjustments of account balances toward their long-run levels.

ProBanker determines each Rate-Set item's current volume by combining the effects of short-run cus-tomer complacency with a longer-run attention to effective rates. First, ProBanker compares each bank'seffective rate with the average applicable rate in that Region, the rate on other (similar) loans or depos-its, and bond market yields. (For example, your customers will compare your INST rate and yourMORT rate. If the latter rate is much lower than the former, they may increase the size of their mort-gage loan and use the excess to pay for a new car. In the real world, there are also personal tax reasonsto do as much of your borrowing as possible on the security of your primary residence, but these effectsare not included in ProBanker.)

Effective Rate of Interest

Customers consider more than just the posted interest rate when evaluating the attractiveness ofa bank's loans and deposits. They compute an effective interest rate by combining the explicitinterest rate, advertising expenditures, and fees charged. Customers then compare effectiverates across Regional competitors (and against open market alternatives) in order to pick thebest deal.

Holding other things constant, an asset account's long-run balance is greater:

• the lower is the effective interest rate charged,

ProBanker's Financial Structure (Details)

29

• the higher is the effective rate charged by Regional competitors, and

• the higher is the market rate on similar-maturity government bonds.

Similarly, the higher balances appear in a Rate-Set deposit account when:

• the effective rate paid is higher,

• the effective rate paid by Regional competitors is lower, and

• the rate on similar-maturity government bonds is lower.

All asset and liability balances are higher when the economy's macroeconomic activity (GDP) is high.This constitutes an "income effect": when the economy is doing well, some people have more savings toinvest in bank deposits, while other people have the confidence to take on more debt. Also, when firmsexperience high demand for their products, they need more loans to finance inventory, pay their work-ers, and so forth.

ProBanker combines all these effects to determine each bank's long-run equilibrium loan or depositvolume, which would emerge if all prices and other conditions in the Region remained unchanged for avery long time. As you can see, this is only a theoretical construct!

Second, ProBanker factors in the effects of customer relationships to determine the present quarter's(short-run) loan or deposit volume. The actual account balance is computed as a weighted average of thelong-run value (described above) and the prior period's balance. The strength of the customer relation-ship for a given bank product is reflected in how quickly the balances adjust to their long run levels.Suppose, for example, that passbook balances have an adjustment speed of 30% per quarter. (They don'tnecessarily.) Then the passbook balance in period t is given by

PASSt = (0.3)PASS*t + (0.7)PASSt-1

where PASS*t is the long run equilibrium passbook volume (based on deposit rates, market rates, GDP,

and advertising at time t) and PASSt-1 is the prior quarter's account balance. A stronger customer rela-tionship makes the constant multiplying PASS*

t smaller, and the constant multiplying PASSt-1 larger.

The individual asset and liability categories differ in their speeds of adjustment. Stronger customer rela-tionships make account balances less sensitive to short-run changes in account pricing, and thereforecorrespond to lower adjustment speeds. Generally, smaller accounts and those with shorter maturitiesare less price-sensitive. For example, customer relationship effects are more important for passbook ac-counts than for IRAs or corporate loans.

Customers are not blindly loyal to their current banks. If you set an excessively high loan rate or an ex-tremely low deposit rate, customers will abandon you in droves. You will then need to re-incur the ex-pense of recruiting new customers to replace the ones you have lost. It's not profitable to exploit yourcustomer relationships too aggressively.

4.3. Operating Costs, Part INearly all bank activities require the expenditure of costly real resources. Loan officers and tellers mustbe paid, computer systems maintained, buildings heated and lit, etc. Your pricing, investment, and fund-ing decisions must take into account the associated noninterest operating costs, which tend to raise yourcost of funds and reduce your return on assets. (Some examples in Section 6.1 show how to incorporateoperating costs into your pricing decisions.)

ProBanker's operating costs are determined in one of the two ways. First, some accounts incur operatingexpenses just like most brokerage accounts: you pay to buy or sell, but not to keep the security in yourportfolio. Such costs apply to all of the perfect market assets and liabilities: you can purchase perfectmarket assets (BONDS, FFS) or sell perfect market liabilities (FFP, Negotiable CDs, DWA) at a trans-action cost that is proportional to the dollar amount purchased or sold.


30

Operating costs are more complex for accounts with valuable customer relationship aspects. These Rate-Set items accrue operating costs that vary with both new account relationships and account balances.Since you are trying to win new customers, and you expect to keep those customers for quite a longtime, it makes sense to bear extra costs in order to attract new accounts. Once you have a customer's ac-count, you also provide costly services (in addition to paying interest on deposits and perhaps offering alower loan rate to "valued customers").

Completely analyzing these cost structures is pretty tricky, and for many purposes it is not worth the ef-fort required. So what are you supposed to do? We have a Shortcut and an Offer.

The Shortcut: just assume that all operating costs are proportional to the account balances. If you have$300,000 in IRA balances and the operating costs reported on the income statement for IRAs if $3,000,then you should assume that your cost of servicing IRA balances is 1% per quarter. (Don't forget to an-nualize that cost, since you'll be thinking in terms of annual interest rates on bonds, etc.) This shortcut issufficiently accurate in most situations.

The Offer: We'll tell you all the details, but only if you want to hear them. If you are just getting startedwith ProBanker, plan on using the Shortcut and skip over Section 4.4. Maybe you'll come back to Sec-tion 4.4 later; maybe not.

4.4. Operating Costs, Part II (optional)OK, you asked for it. Here are some examples of how ProBanker actually computes operating costs.

4.4.1. Operating Cost Example #1: Fixed-rate loansFixed Rate corporate loans (FR) incur two components of quarterly transaction costs:

• A "maintenance" cost, proportional to the dollar account balance.

• An "account setup" cost, which is proportional to the amount by which this period's loan balancesexceed last period's.

The Income and Expense Report shows "Other Noninterest Operating Costs" for each balance sheet cat-egory. For FR loans, this transaction cost is computed as

TCt = M FR + S max[0, FRt - FRt-1]

where

• M is the cost required to maintain a dollar of FR loans for one calendar quarter,

• FR is the dollar volume of fixed rate loans,

• S is the cost of setting up a new dollar of FR loans, and

• the "max" function denotes the maximum of the two items in square brackets.

4.4.2. Operating Cost Example #2: Multi-period mortgageloans

Assume that your quarterly maintenance cost ("M") is 0.20% of the account balance for MORT, whileyour account setup cost ("S") for mortgage loans is 0.3% of added loan volume. (These are not necessar-ily the correct values!)

Suppose that last quarter your bank had $25 million outstanding in each of the eight mortgage maturit-


31

ies, for a total of $200 million. At the start of the present quarter, $25 million of those loans mature.Suppose your MORT pricing decisions yield $30 million in new, 8-period mortgage loans.

Then your MORT operating costs for the present quarter will be:

• A maintenance cost of $410,000, which is 0.20% of the $205 million in outstanding mortgage loans.

• New account setup costs of $15,000, which is 0.3% of the net increase in MORT loans. (You paythis setup cost once, and keep MORT loans on your books for 8 quarters. Section 6.1 discusses howto amortize those setup costs in order to compute an appropriate annualized cost for MORT and forother multi-period account balances.)

You will see the sum of these two items (namely $425,000) as "Other Noninterest Operating Costs" forMortgages.

These noninterest operating costs have two managerial implications. First, remember to consider operat-ing costs when choosing your loan and deposit rates. Second, try to maintain Rate-Set accounts at a con-stant (or increasing) dollar volume, because temporary volume declines generate subsequent readjust-ment costs.

Table 4.1 summarizes the type of transaction cost(s) that apply to each account.

Table 4.1. Transaction Costs Associated with ProBanker Accounts

Asset Accounts Liability Accounts

"None" indicates that changes to the value of this account never incur transaction costs.

"S" indicates a cost that is paid only when the balances are first acquired.

"M" is a recurring cost of maintaining (servicing) balances in the account.

Required Reserves None

Excess Reserves None

Federal Funds Sold S Federal Funds Purchased S

Fixed Rate Corp. Loans S, M Demand Deposits S, M

Floating Rate Corp. Loans S, M Negotiable CDs S, M

Retail Installment Loans S, M Passbook S, M

Mortgages S, M Retail CDs S, M

Bonds S IRAs S, M

Fixed Assets None Net Worth None

Loan Loss Allowance (contra) None Discount Window Advances None

4.5. Detailed Account DescriptionsNow we provide details about the features of each Balance Sheet asset and liability account. See Sec-tion 4.3 and Section 4.4 for information about operating costs on these accounts.

4.5.1. Asset Accounts

4.5.1.1. Required Reserves (RR)

Banks must keep reserve balances at the Federal Reserve Bank, in proportion to their outstanding depos-it liabilities. (The Economic Environment Report describes required reserve ratios, which can change


32

over the course of your simulation.) The dollar volume of Required Reserves cannot be known exactlywhen you are making your decisions, because it depends on your realized deposit balances. Playersshould estimate their deposit balances, and choose an Initial Reserve Allocation sufficient to satisfy anti-cipated reserve requirements. If your bank turns out to need reserves in excess of your Initial ReserveAllocation, ProBanker will automatically reduce Federal Funds sold (FFS) or borrow at the DiscountWindow. Any funds transferred from the latter sources to fulfill RR are assessed a proportional transac-tion cost of 0.5%. (Note: this cost is not an annualized rate.)

4.5.1.2. Excess Reserves (ER)

If your "Initial Reserve Allocation" exceeds the level of required reserves, the excess will be held as de-posits due from other banks. Although U.S. banks may not (by law) pay explicit interest on these bal-ances, they will perform free services in proportion to the balances you hold with them. These free ser-vices frequently relate to check clearing, and hence lower the cost of servicing your demand deposit cus-tomers. ER balances earn implicit interest at a rate equal to about 90% (more precisely, 1.0 minus theDDC reserve requirement) of the period's average risk-free federal funds rate. (This rate of implicit com-pensation for interbank demand balances assumes perfect competition for such balances.) If implicit in-terest earned exceeds noninterest DD operating costs, the excess is lost to the bank. ER balances incurno transaction costs.

4.5.1.3. Federal Funds Sold (FFS)

The CEO chooses how much to lend to other banks and financial institutions through the Federal Fundsmarket. FFS earn an expected return equal to the riskless 90-day CD rate, which is known for certainwhen Bank decisions are made. However, the actual FFS rate will differ from the 90-day CD rate by arandom factor that reflects unanticipated money market developments during the quarter. (Because mostFFS lending has a very short maturity the average Fed Funds rate over the coming quarter cannot beknown when you are making your decisions.) Your bank's ultimate FFS position also may differ fromwhat you entered as an initial decision, because FFS balances play an important part in the process forbalancing each bank's balance sheet. (Section 4.11 below provides details.)

4.5.1.4. Fixed Rate Corporate Loans (FR)

You select a contract rate to charge on these one-period corporate loans. Your bank's FR volume de-pends upon (among other things) the level of market interest rates, GDP, competing banks' FR rates, andcustomers' expected cost of your bank's floating rate loans. There is an element of short-term customerloyalty in the FR market, which makes the present volume of loans depend on past volumes. Finally, thebank can choose credit standards (the "Corporate Loan Standard" on the Decision Page) that affect de-fault probability, operating costs, and loan volumes. (See Section 4.6.)

4.5.1.5. Floating Rate Corporate Loans (FL)

These two-period loans are priced as a SPREAD over an economy-wide "floating rate loan base," whichis the average of the 90-day CD rate and the quarter's risk-free Federal Funds rate. A loan's SPREADstays constant throughout its life, although its actual interest rate varies with the floating rate loan base.FL demand is inversely related to the average contract rate that customers expect to pay over the loan'stwo-period life. (The expected FL contract rate is the average of this period's rate and the expected ratenext period, given the bank's SPREAD and the forward rate implied by the government bond term struc-ture.) FL volume is also affected by the determinants of FR.

4.5.1.6. Installment Loans (INST)

These consumer loans mature in four periods. The CEO chooses a loan rate and an (dollar) advertisinglevel directed at the INST market. INST customers are moderately responsive to advertising. A bank'smarket share tends to persist through time, due to moderately strong customer relationship effects.


33

4.5.1.7. Household Mortgages (MORT)

These 8-period loans have a fixed contract rate and are not marketable. Advertising expenditures havesome effect on the bank's new MORT flow, though not so much as for INST. Customer relationship ef-fects are also smaller than for INST, though still present.

4.5.1.8. Bonds (BOND)

The CEO may purchase new government bonds, which carry a fixed interest rate and mature in 8 peri-ods. New bonds are purchased at par, and the bank's accountants carry bonds on the balance sheet attheir acquisition cost. However, subsequent market rate changes affect bond market values. (A bond'scurrent market value is obtained by discounting its remaining cash flows at the riskless interest rate forthe corresponding time to maturity. These rates are reported in the Bond Market Report.) The CEO cansell seasoned bonds by specifying the maturity date and book value of bonds to be sold. (ProBankerprovides no opportunity to purchase seasoned bonds.) The Economic Environment Report specifies thecorporate tax rate on capital gains (losses) when bonds are sold before maturity.

4.5.1.9. Fixed Assets (FA)

The bank utilizes fixed assets (land, buildings, equipment, furniture) to produce financial intermediationservices. These assets depreciate at an exogenous rate, generating quarterly operating expenses. Youcannot change the level of your bank's fixed asset stock, or its depreciation rate.

4.5.1.10. Loan Loss Allowance (LLA)

A single loan loss allowance account serves as a reserve ("contra-account") for customer defaults on allfour loan types. Losses are charged to this account when they occur; LLA is replenished via the expenseitem Provision for Loan Losses (PLL).

Another term for the loan loss allowance (LLA) is the "Loan Loss Reserve." Nonfinancial firms showmany such reserve accounts as part of their net worth. For banks, the LLA is generally shown on the as-set side of the balance sheet:

Gross Loans: $135

(Less: Loan Loss Allowance): ($ 7)

Net Loans: $128

The typical bank balance sheet shows net loans.

4.5.2. Liability AccountsDeposit insurance note: Each of the following six deposit liabilities (DDR, DDC, CD, PASS, RetailCDs, IRA) is subject to an annual charge for FDIC insurance coverage and may carry a non-zero reserverequirement. (Negotiable CDs bear an insurance premium despite the fact that each account is insuredonly up to $100,000, which makes most Negotiable CD balances uninsured.) Current reserve require-ments and the insurance fee are provided each quarter in the Regulatory Environment Report.

4.5.2.1. Federal Funds Purchased (FFP)

The CEO can borrow from other banks and financial institutions through the overnight Federal Fundsmarket. If some purchased funds turn out to be un-needed, the bank pays a transaction cost to borrowthem initially and to re-lend them in the market as FFS. (See Section 4.11.)

A sound bank will pay a rate on FFP is equal to that earned on FFS. However, as a bank's leverage in-


34

creases above some threshold value, its interest rate paid on FFP may include a default risk premium.Market investors will also stop lending to a bank that appears too risky. FFP pricing and rationing areboth described in Section 4.8.

4.5.2.2. Demand Deposits (DDR, DDC)

Under current U.S. law, banks may not pay explicit interest on any type of demand deposit account.However, ProBanker permits your Administrator to set positive interest rate ceilings on either type ofdemand deposit--so check your Regulatory Environment Report to see what regulations apply to yoursimulations.

In addition to the possibility of explicit interest payments, ProBanker banks compete for demand depositby paying implicit interest in two forms. First, you can direct advertising expenditures to either type ofDD account. Second, you can vary the level of your checking-related fees to make your DD accountsmore or less attractive. Lower fees elicit greater DD account balances, but your noninterest revenue willalso be lower. Setting the fee rate above 100% makes DD services a profitable activity, but it reducesyour available "interest free" DD balances.

Both types of DD balances are positively related to the effective rate paid on them, negatively related tothe level of market interest rates, and positively related to the level of GDP. DDC are more interest-elast-ic than DDR. Demand deposit accounts have substantial customer relationship effects, especially amongretail customers. DDC balances differ from DDR in two additional ways:

• DDC balances increase with the volume of corporate loans outstanding, reflecting the compensatingbalance arrangements that often accompany FR and FL.

• DDC balances fall when the bank's leverage increases beyond some critical level, as customers fearthat they will lose their uninsured funds if the bank fails. (See Section 4.8.)

4.5.2.3. Negotiable Certificates of Deposit (CD)

Under normal circumstances CEOs may sell as many (or few) CDs as they desire, with initial maturitiesof 1, 2 or 4 quarters. In deciding how many CDs to issue, be careful to note that old CDs "age down" astime passes: last period's 4-quarter CDs become this period's 3-quarter CDs, and so forth.

Riskless CD rates for the coming quarter equal the same-maturity government bond's yield, as reportedin ProBanker's (two) end-of-quarter Bond Reports. However, a highly levered bank's actual cost of CDfunds may incorporate a default premium above the riskless rate. The market also refuses to purchaseCDs at any price once the bank's leverage has become sufficiently high. See Section 4.8.

4.5.2.4. Passbook Saving Accounts (PASS)

These retail savings accounts have no fixed maturity, and reputation (customer relationship) effects arevery important. PASS balances are positively related to the effective rate you pay, negatively related tothe effective rate paid by your Regional competitors, and negatively related to the level of governmentbond yields. The PASS reserve requirement and interest rate ceiling (if any) can be found in the Eco-nomic Environment Report.

4.5.2.5. Retail Certificate of Deposit (RCD)

These are fixed-rate, two-period retail accounts, also called "Retail CDs." RCD balances are sensitive tothe same factors as PASS, but reputation and implicit interest (advertising) effects are less important forthe RCDs. Your administrator may impose a deposit rate ceiling or reserve requirement on Retail CDs,which will be reported in the Economic Environment Report. (For technical reasons, the absence of aneffective deposit rate ceiling on Retail CDs appears in the Economic Environment Report as a very largenegative number.)


35

4.5.2.6. Long-term Retail Time Deposits (IRA)

These are fixed rate, 8-period retail accounts, subject to the same economic forces as PASS and RetailCDs. Implicit interest and reputation effects are moderate -- that is, lower than for Retail CDs. Your ad-ministrator may impose a deposit rate ceiling or reserve requirement for IRA accounts, which will benoted in the Economic Environment Report.

4.5.2.7. Discount Window Advances (DWA)

ProBanker chooses this amount to balance the balance sheet if your other liabilities are insufficient tofund the assets you have purchased. The bank pays interest at a rate above its rate on federal funds bor-rowed (FFP). (Recall that the FFP rate can include a default risk premium for a highly leveraged bank.)This penalty rate gives the CEO an incentive to forecast balance sheet positions carefully each period.Compute the DWA's rate premium from information on your Full Balance Sheet Report: subtract therate you paid on on FFP from the rate paid on DWA.

Discount Window Advances

ProBanker's Discount Window differs quite substantially from the Federal Reserve's lending fa-cility, which is also called the Discount Window. In ProBanker, DWA lending is unsecured,quite expensive (compared to Fed Funds), and can be provided in very large amounts.

Historically, the Fed set its Discount Window Advance rate below the Fed Funds rate and ra-tioned (restricted) Discount Window access. A new regime was introduced on January 9, 2003,in which banks were provided much freer access to the Window. But now the rate is a premiumover the federal funds rate. During most of 2003, this premium was 100 basis points (1%). Asin the past, the Fed lends only on a secured basis; borrowing banks must deposit acceptable col-lateral with their district Federal Reserve Bank in anticipation of any borrowing request.

4.5.2.8. Net Worth (NW)

Owner's paid-in capital and retained earnings determine the bank's level of equity capital. Higher di-vidend payments reduce NW, while lower dividends or (naturally) higher profits raise it. The CEO canalso change New Worth by selling new stock or repurchasing stock from the open market. Section 4.10describes how the market values bank shares. The Net Worth account must fulfill the capital adequacyregulations, which are described in Section 4.9.

4.6. Loan Losses and Non-Performing LoansProBanker loans cannot default before maturity because their only principal repayment occurs at the fi-nal maturity date. Prior to maturity, however, some loans become "nonperforming," which means theyfail to make their contractual (quarterly) interest payments. At maturity, some loans will also default:that is, fail to repay principal as promised.

Table 4.2 shows a quarterly Loan Performance Report. The "Percent Defaulted" column applies to loansthat matured at the first instant of the most recent period. The "Percent Nonperforming" column refers tothe entire stock of loans outstanding at the end of the most recent quarter. (Note: because an FR loanlasts only one quarter, the FR "nonperforming" rate exactly equals the proportion "lost.")

You can forecast future default losses from current nonperformance levels, because next period's defaultrate will equal approximately 75% of the "Percent Nonperforming". The actual default rate will varywith macroeconomic conditions: higher GDP improves loan performance, while higher market bondrates reduce loan quality. Your loan performance also varies with the underwriting standard you appliedwhen the loans were first negotiated.


36

Table 4.2. Loan Performance Report



Loan Performance Report: Quarter 0

Matured Last Defaulted Percent Percent Nonperforming

Qtr. ($1,000s) ($1,000s) Defaulted Nonperforming ($1,000s)

Fixed Rate 170,345.14 147.46 0.09 0.14 208.58

Floating Rate 277,296.45 522.05 0.19 0.30 1,311.55

Installment 90,377.41 710.16 0.79 0.98 3,441.84

Mortgage 55,552.30 39.11 0.07 0.10 417.75

Totals 593,571.31 1,418.78 5,379.72

Your loan rates should be high enough to compensate for expected losses. Because you are setting anannual interest rate on loans, you need to annualize your expected loss rates. The loan product's maturitydetermines the proper way to annualize expected losses. Section 6.1.3 provides details, but here we offertwo examples. First, Table 4.2 indicates that about 0.09% of one-period FR loans are expected to de-fault. This implies an annual loss rate on FR loans of about 0.36% of the average balances outstanding--because you make four successive FR loans each year, expecting to lose 0.09% of principal each time.The (annual) loan rate charged on FR should therefore be at least 36 basis points above riskless marketrates.

Second, let's look at the 2-period FL in Table 4.2. The FL "Percent Nonperforming" ratio of 0.3% im-plies that you should expect defaults of 0.225% ( = 75% of 0.3%) out of each loan dollar that matures.Because FL loans have a two-quarter maturity, annual losses will be 0.45% of average FL balances out-standing -- 0.225% losses per loan times two turnovers of the loan portfolio annually.

4.6.1. Controlling Credit QualityBank managers can affect the level of FR and FL loan losses by specifying the level of credit standardsto be applied to loan applications. A high (+1) Corporate Loan Standard (CLS) reduces the proportion ofnonperforming and defaulted loans, but fewer loans get made at any specified loan rate. In addition,noninterest loan expenses are higher when high credit standards are applied. On net, a high standardslightly lowers the expected net return on corporate loans, while also reducing the variability of thosenet returns. You have no control over the credit quality of INST or MORT.

4.6.2. Accounting for Loan LossesActual losses on maturing loans are charged to the Loan Loss Allowance (LLA) contra-asset accountwhen they occur, on the first day of each simulation period. LLA changes through time in the followingway

LLAt = LLAt-1 + PLLt - (Actual Losses)t

where PLL is the Provision for Loan Losses, which is a decision variable.

Because the LLA is a contra account to gross loans, it is properly considered part of bank equity capital.(This procedure is analogous to establishing a reserve against any contingency.) Nevertheless, bankingconvention dictates that the LLA be shown on the asset side of the balance sheet. Moreover, conventiondictates that a bank's asset size be computed net of expected losses:


37

Total Net Assets = Total Gross Assets – LLA

which is the same as

Total Net Assets = Total Liabilities + Net Worth.

4.6.3. Bank Examinations and the LLABecause the value of most bank loans depends importantly on private information about the borrower'sfinancial condition, outside investors (including depositors) may find it difficult to value a bank's loanportfolio. One useful indicator of loan quality is the LLA. Both Generally Accepted Accounting Prin-ciples (GAAP) and federal regulations require that a bank's LLA reflect management's best estimate offuture loan losses for the assets currently in place.

Bank regulators are extremely concerned that the LLA accurately reflect the loan portfolio's true quality.They therefore require your bank to maintain a LLA that exceeds a fixed proportion of your total Non-performing Loans. (This proportion can be found in the Economic Environment Report: "LLA requiredfor nonperforming loans.")

Each quarter, you should select a PLL expense that will make your end-of-quarter LLA satisfy the re-quired relation between LLA and the volume of Nonperforming Loans. PLL is a deductible expense forincome tax purposes up to your bank's actual default losses in each period. (The Tax Reform Act of1986 introduced this tax treatment for financial institutions' loan losses.) ProBanker's stock market inter-prets the PLL as the CEO's best estimate of eventual loan losses. In other words, investors treat PLL as atrue operating expense.

If your PLL transfer does not produce a sufficient LLA, examiners require the bank to transfer from theNet Worth account into LLA. The reported PLL expense will then equal the sum of what managers ini-tially specified, plus the additional transfer out of NW. Regulators impose a "hassle cost" equal to 2% ofthe amount transferred, which is recorded on the income statement under "other transaction costs."

4.7. Macroeconomic Effects on Your BankMacroeconomic developments include the growth rate of GDP and changes in the term structure of gov-ernment bond rates. These developments affect all banks, in all competitive Regions, to the same extent.

The level of GDP affects the demand for loans and the supply of deposits: for any given loan (deposit)rate, a higher GDP means that all banks will have larger account balances. Macroeconomic conditionsalso influence banks' nonperforming loans and default ratios: higher GDP and lower market (bond) in-terest rates tend to reduce loan problems.

The GDP trend is positive. Each quarter, GDP tends to grow at a rate equal to the short-term (90-day)government bond rate. Although you will notice considerable variation in GDP growth, keeping its ex-pected growth rate in mind will help you predict loan demands, deposit supplies, and loan default losses.

The "Bond Portfolio Report" in Table 4.3 is provided to all banks at the end of each quarter. The MarketYield column shows the yields to maturity for all outstanding government bonds. (Remember that therates on riskless negotiable CDs equal the government rates: 4.23%, 5.03%, and 5.23% in Table 4.3.Highly levered banks will pay a default premium above G-bond rate when they issue Negotiable CDs.)These rates evolve over time according to the Expectations Hypothesis of the term structure which is ex-plained in a separate ProBanker Economics Lesson: The Term Structure of Interest Rates. (Select the"Help" button on your Main Page, then click on the paper's title to download.)

ProBanker's interest rate volatility is considerably greater than what we observe in the real world:without extra variability, even the longest maturity assets and liabilities would have relatively smallmarket value fluctuations. At the expense of some empirical reality, therefore we include a significant


38

amount of potential interest rate risk for bank equity holders.

Table 4.3. Bond Portfolio Report

Bank: Regional-Low Cost Template

Player: Jane Doe

Bond Portfolio Report: Quarter 0

Book Value of Portfolio 180,000.00

Market Value of Portfolio 181,163.61

Maturity (start of) Coupon Rate Market Price Market Yield Bank Holdings

Quarter T+1 1,000.00 22,500.00

Quarter T+2 62.30 1,004.95 4.23 22,500.00

Quarter T+3 62.30 1,006.90 4.83 22,500.00

Quarter T+4 62.30 1,008.82 5.03 22,500.00

Quarter T+5 62.30 1,009.77 5.23 22,500.00

Quarter T+6 62.30 1,009.18 5.48 22,500.00

Quarter T+7 62.30 1,007.46 5.73 22,500.00

Quarter T+8 62.30 1,004.63 5.98 22,500.00

Quarter T+9 62.30 1,000.00 6.23

Although the interest rates on government bonds are known with certainty at the start of each period, therate on Federal Funds is not. Since these overnight rates can change in unanticipated ways, the averagecost of federal funds (FFP and FFS) remains unknown until the quarter's end. You have some idea of thelikely fed funds rate at the start of the quarter, because the expected (in a statistical sense) Federal Fundsrate equals the 90-day CD rate, which (in its turn) equals the yield on 1-quarter government bonds. Theactual Funds rate will differ from the 90-day CD rate by a random amount. Since the cost of DiscountWindow Advances is related to the FFP rate, the discount rate is also unknown until the end of thequarter.

Finally, a word about the relation between GDP and interest rates. Unlike what you probably learned inyour economics classes -- and what is also true in the real-world economy -- GDP changes do not dir-ectly affect the level of market interest rates in ProBanker. Nor do interest rate changes affect GDP inProBanker. Your best forecast about the level of future interest rates is always derived exclusively fromthe current term structure. Unless your administrator explicitly tells you otherwise, market interest rateswill not fall during an economic recession. Nor will they tend to rise if the economy grows quickly.

4.8. Bank Leverage and Purchased FundsThe Federal Deposit Insurance Corporation (FDIC) fully insures all retail liabilities in ProBanker. As aresult, retail depositors do not consider your bank's financial condition when they are deciding where todeposit their funds. In contrast, everyone assumes that larger, wholesale liabilities are completely unin-sured. This makes large liability-holders (negotiable CDs, FFP, DDC) sensitive to your bank's risk ofdefault.

Market investors measure your bank's riskiness as its leverage, computed as the ratio of Net Total Assetsto Tier 1 capital (which includes only Net Worth in ProBanker). Greater leverage increases your probab-ility of failure, even while it raises the expected return on owners' equity. Below some "critical" leveragelevel, banks can issue uninsured liabilities at riskless market rates, and the market supplies the fullamount requested. Above that level, however, the required rate on new negotiable CDs and FederalFunds Purchased increases with leverage, at an increasing rate.


39

Corporate demand depositors also respond to high bank leverage, by holding lower DDC balances forany offered effective rate. This effect increases with bank leverage, at an increasing rate.

The market's critical leverage value is controlled by your administrator, who will generally require thatbank CEOs try to infer this value for themselves. The critical leverage ratio may vary through time, al-though the Administrator will probably announce changes in the degree of investor confidence. Youhave two ways to determine if your bank's leverage is in the "default premium" zone. (Either one is suf-ficient.)

• Compare the rates reported on your Full Balance Sheet for FFS and FFP. FFS always earn the risk-less Federal Funds rate. If your FFP rate exceeds the FFS rate, your bank is paying a default premi-um on its uninsured liabilities.

• Compare your bank's rate on 4-quarter negotiable CDs to the 4-quarter government bond rate. If theCD rate exceeds the government bond rate, investors are charging you a default risk premium.

Paying a credit risk premium on your large liabilities is not necessarily unprofitable, because higherleverage tends to raise your shareholders' expected return. If you find that the market is charging you adefault risk premium, you should determine whether it is better to reduce your leverage, or to continuepaying the premium. Be sure to consider all the possible responses:

• Reduce leverage enough to eliminate the premium entirely,

• Reduce leverage somewhat to eliminate part of the premium, or

• Continue paying the premium.

Unless you can compare the net effect (profitability) of all three possible actions, you cannot make agood choice about how to respond to your leverage situation.

Finally, investors may sometimes ration your bank, and refuse to purchase further liabilities at anypromised interest rate. This reflects the real-world tendency of uninsured claimants to run against (i.e.,withdraw their funds from) banks that are suspected of being near insolvency. In ProBanker, if yourleverage gets so high that the required rate on uninsured liabilities exceeds the riskless rate by more thansome critical value (the default value is an annual premium of 6%, but your administrator can change it),the bank can obtain no further FFP or CD funds. Since you will already have committed yourself to pur-chase specific assets by the time the market decides to ration you, ProBanker forces you to borrow fundsfrom the Discount Window.

You can determine if your bank is being rationed in the FFP and CD markets by comparing your reques-ted CD volumes with the amounts that finally appear on your balance sheet. If you asked for $100 mil-lion of new, 4-period CDs and got only $73 million, you will know that the market is rationing your is-suance of these uninsured obligations.

4.9. Capital and Capital AdequacyThe LLA protects the bank against expected loan losses, but bank equity capital must absorb other risks(e.g., unanticipated loan losses, operating cost uncertainty, interest rate fluctuations). Bankers and regu-lators tend to have different perspectives on how much equity capital is required. For bankers, lower NetWorth (higher leverage) has the advantage of raising the expected return on shareholders' equity. Offset-ting this advantage of leverage, uninsured liability holders will demand a risk premium from highlylevered banks. For banks with substantial amounts of insured deposit liabilities, however, the averagecost of deposits does not rise very much when leverage increases, making shareholders better off withmore leverage.

By contrast, regulators try to assure that banks operate in a safe and sound manner. Regulators thereforetend to prefer lower bank leverage. In ProBanker, regulators specify a minimum level of protection forall bank creditors via two (related) standards:


40

• Risk-Based Capital: Each bank must hold equity capital equal to a minimum percentage of its credit-risk-weighted assets.

• Leverage Constraint: Net Worth must exceed a minimum proportion of its total net assets (that is,net of LLA).

These are the "capital adequacy" requirements associated with the U.S. regulators' implementation of the1988 Basel Capital Accord.

The Basel standard recognizes two types of equity capital:

• Tier I capital, which in ProBanker equals "net worth plus retained earnings", and

• Tier II capital, which in ProBanker equals LLA (up to 1.25% of Risk-Weighted Assets).

Probanker initially requires that the sum of these two equity types equal at least 8% of Risk-WeightedAssets. The Leverage Constraint initially requires that (NW/TA) equal at least 5%. However, your Ad-ministrator can change these cutoff values, so check the Economic Environment Report each quarter forcurrent capital adequacy standards.

The Basel (Basle) Capital Standards

Prior to 1988, each country imposed its own set of capital-adequacy requirements on its banks.Problems arose because many banks were operating across national boundaries, and differentcountries required different levels of capital for the same assets. Bankers therefore tended toshuffle some of their assets between different subsidiaries in different countries, to generate thelowest overall capital requirement. In response to this situation, about a dozen central banksbegan meeting under the auspices of the Bank for International Settlements (which is located inBasel, Switzerland) to design a common set of capital standards for major banks. The first setof capital standards was completed in July 1988, and involved only the bank's credit (default)risk exposures. U.S. regulators fully implemented those risk-based standards by the end of1992.

Subsequent Basel discussions have sought to incorporate banking firms' interest rate and mar-ket risk exposures into risk-based capital requirements. In August of 1995, U.S. regulators an-nounced that they would henceforth consider a bank's interest rate risk exposure when determ-ining its "adequate" level of capital. After struggling to find an accurate method of measuringthese risks, however, U.S. regulators concluded that no single model could accurately assessthe majority of banks' exposures. On June 26, 1996, the agencies abandoned their efforts to de-vise a generic model of interest rate risk, and now judge these exposures on a case-by-casebasis.

The banking agencies have incorporated "market risk" into their formal risk-based capitalstandards, but only for very large institutions. Effective January 1, 1998, any bank or bankingholding company whose trading activities exceed the smaller of $1 billion or 10% of the insti-tution's total assets, must hold capital to protect against losses in their foreign exchange, equity,interest-rate, or commodity trading books. (Federal Register 61(174), pp. 47361-47362.) Theamount of this capital can be specified by each banks' own internal model of the largest loss itexpects to incur (at the 99% confidence level). This capital will be added to the capital requiredto cover the institution's credit risk on traditional activities.

See www.bis.org [http://www.bis.org/index.htm] for ongoing developments in worldwide cap-ital adequacy regulation.

ProBanker's risk-based capital requirement reflects only the credit risk component of the Basel I stand-ards. Risk weighted capital standards assign each asset to a credit risk category:

• 0% risk weight: Required Reserves (RR), Government bonds.


41

http://www.bis.org/index.htm

• 20% risk weight: Excess reserves (ER), Federal funds sold (FFS).

• 50% risk weight: Mortgage loans secured by 1 - 4 family residential properties (MORT).

• 100% risk weight: All other assets (INST, FR, FL, FA).

These risk weights correspond to the U.S. implementation of the Basel Accord's credit-risk-based capitalstandard. Total risk assets are computed as the weighted sum of the dollar values of each risk category.

Table 4.4 presents a sample Capitalization Report, which describes you current (and recent past) regulat-ory capital position.

Table 4.4. Capitalization Report



Capitalization Report: Quarter 0

Current Preceding

Quarter Quarter

Price Per Share 27.93 27.46

Market Value of Equity 119,844.57 117,823.69

Book Value of Equity 117,600.60 117,600.60

Number of Shares Outstanding 4,291,125 4,291,125

Number of Shares Sold by Management 0 0

Price 0.00 0.00

Number of Shares Sold by Regulators 0 0

Price 0.00 0.00

Dividends Paid 0.00 0.00

Net Total Assets 1,590,902.46 1,685,980.48

Risk-weighted Assets 1,172,915.08 1,260,641.62

Basel Tier I Ratio 10.03 9.33

Basel Tier I+II Ratio 10.52 9.70

Capital/Asset Ratio 7.39 6.98

Each period, the regulator determines whether your bank complies with the prevailing capital standards.How and when? At the start of each quarter, ProBanker makes only two changes before assessing yourcompliance with capital adequacy requirements.

1. The simulation pays out the dividends you have requested, which lowers your capital ratios.

2. If the bank still has positive Net Worth after paying dividends, the simulation executes the man-ager's share issuance request. If your bank is under-capitalized, you should issue additional shares,which means you enter a positive number into the "Number of shares to sell" decision. Shares arepriced close to the prior quarter's closing price, but the more shares you sell, the lower the pricewill be.

If your bank is still short of capital after any voluntary stock sales have been completed, the regulatorforces the sale of sufficient stock to get Net Worth to exceed the most binding capital requirement byabout 2% of risk-weighted assets, or 10% of risk assets (whichever is larger). The market's awareness ofthe bank's regulatory problems reduces the sale price to 80% of what it would have been if you had soldshares voluntarily. It is thus extremely imprudent to let the regulators force you into selling stock. You


42

can avoid a forced sale by specifying a positive "Number of Shares to Sell" as soon as you realize thatyour Net Worth has become inadequate -- but you only get one chance!

Now, what if your bank is close to the minimum capital ratio, but not yet in violation? You can raiseyour bank's capital ratio by increasing Net Worth or reducing total assets. We've already discussed howto raise Net Worth. To reduce assets, consider selling your government bonds, lowering your FFS, orraising loan rates. If you have more deposits than loans, you may need to lower deposit rates or reduceyour FFP or Negotiable CDs.

Finally, you may find yourself with too much capital: the low leverage is reducing shareholders' expec-ted return. To distribute capital out of the firm, you can either pay dividends or repurchase some of yourshares from the market. (To repurchase shares, enter a negative "Number of Shares to Sell.")

When you sell new equity or re-purchase outstanding shares in the market, the price of those shares iscomputed to reflect the dilution of ownership. The proceeds from selling the new shares (less an 8% un-derwriter's commission) is credited to Net Worth. With a stock repurchase, Net Worth is reduced by themarket value of the purchased stock plus the underwriter's commission.

If a bank tries to repurchase shares with a market value in excess of current Net Worth, ProBanker re-duces the number of shares repurchased until Net Worth exceeds their market value. The bank musthave at least one share of stock outstanding at all times.

In an extreme situation, regulators will forcibly close the bank and re-capitalize it. This will happen if:

• "Net Worth Plus Retained Earnings" is negative at the end of a period; or

• "Net Worth Plus Retained Earnings" is too small to cover the transaction costs of floating the newshares that are being offered for sale. (These shares might be voluntarily sold by the CEO, or for-cibly sold by the regulators.)

In either event, the bank is re-capitalized with one million new shares, priced to yield a paid-in capitalthat exceeds the most binding capital requirement by about 2% of the prior period's risk-weighted risk-weighted assets, whichever is greater.

Needless to say, your old shareholders view their bank's closure with considerable displeasure. Happilyfor you, though, they cannot replace bank management. A bank that has been closed and re-capitalizedsometime during the simulation can be easily identified on the Performance Report (Table 4.5), by apositive entry in the "No. times recapitalized" column.

4.10. Market Value of Bank EquityCEOs should attempt to maximize the return to their initial shareholders, which can be calculated as di-vidends paid out plus any increase in the price of your initial shareholders' equity stake. Dividends paidto shareholders over the course of the simulation are tracked cumulatively on the Performance Report(Table 4.5).

Shareholders are assumed to invest all their dividends (and accumulated interest thereon) at the riskless90-day CD rate. Shareholders' personal taxes are not considered.

Share price is calculated as the firm's current market value divided by the number of shares. The bank'smarket value is the NPV of expected future earnings. "Expected future earnings" are calculated as aweighted average of past periods' earnings, net of realized capital gains (losses) on the bond portfolio.(Realized capital gains are not expected to recur, and hence do not affect the bank's market value.) Earn-ings are discounted by a risk-adjusted long-term rate.

A bank's market value is also slightly affected by dividend payments: a history of rising (falling) di-vidend yields raises (lowers) market value somewhat.


43

Table 4.5. Performance Report (Compares Banks)

Game: NewWorld Bancorp, Ltd.


Performance Report: Quarter 0

Number Price Current

Bank Bank Market Times Cumulative per Net

Name Number Market Value Recapitalized Dividends Share Income

Bank A 1 Mkt. A 540,676.58 0 0.00 540.68 21,340.66

Bank B 2 Mkt. A 305,754.60 0 1,572.31 305.75 14,015.65

Bank C 3 Mkt. A 206,296.19 0 0.00 9.09 2,032.33

Bank D 4 Mkt. A 217,058.55 0 0.00 217.06 3,708.58

Bank E 5 Mkt. A 38,523.93 0 0.00 38.52 -4,826.11

Bank F 6 Mkt. A 44,434.79 0 0.00 44.43 -1,631.67

Bank G 7 Mkt. A 83,022.51 0 0.00 83.02 1,372.22

Bank I 8 Mkt. A 173,012.78 0 0.00 173.01 3,115.29

Bank J 9 Mkt. A 54,345.96 0 0.00 54.35 -4,236.16

Bank K 10 Mkt. A 150,884.33 0 0.00 145.82 2,778.43

4.11. Balancing Your Balance SheetBalance sheets must balance. Because the final volume of Rate-Set assets and liabilities is unknownwhen the CEO makes her rate decisions, any simulation game must include a mechanism for adjusting aresidual asset or liability to assure that the balance sheet constraint holds. In ProBanker, excess reserves(ER), Federal Funds Sold (FFS), and the Discount Window (DWA) serve as balancing accounts. Al-though managers choose an initial level for these balance sheet items, the final values depend on thebank's actual deposit and loan flows.

Once all the CEO's initial decisions have been implemented, the bank might, perchance, be perfectlybalanced. More likely, it will turn out asset-heavy or liability-heavy. How does ProBanker produce abalance balance sheet?

4.11.1. When Assets Initially Exceed LiabilitiesA bank in this position has lent more than its managers had arranged to borrow. To close the balancesheet, some asset must be reduced or some liability increased. ProBanker proceeds as follows:

1. Any ER balances are reduced toward zero.

2. If the initial imbalance exceeded the stock of ER, positive FFS is reduced toward zero. (Note:When ProBanker must change your FFS level, you pay a "round-trip" transaction cost on part ofthe FFS volume. For example, if you requested $100 million in FFS, but ProBanker permitted youto sell only $60 million -- because the other $40 million was needed to fulfill loan demand -- youwould pay a proportional charge for $140 million in Fed Funds transactions: the $100 million youinitially purchased, plus the $40 million offsetting re-purchase.)

3. If the initial imbalance exceeded the stock of (ER+FFS), the bank is forced to borrow enough at theDiscount Window to close the balance sheet.

Generally, DWA is such an expensive source of funds that bank managers will wish to avoid it. This can


44

be accomplished by carefully forecasting the bank's sources and uses of loanable funds.

4.11.2. When Liabilities Initially Exceed AssetsThis imbalance arises when the CEO has provided too much funding, compared to asset demand. Insuch cases, the Game simply places the excess loanable funds into FFS.

It might appear that a good way to avoid the Discount Window would be to specify a very large FFPbalance each quarter. Liabilities are then likely to exceed assets, keeping your bank out of the DiscountWindow. While this strategy will work, it has two drawbacks. First, you are charged a transaction cost toborrow the FFP and then (if necessary) to lend them out again in the form of FFS. Second, the resultingbalance sheet expansion raises your leverage, which may lead market participants to charge a defaultpremium on your uninsured liabilities and reduce your DDC balances.

4.12. Reserve RequirementsProBanker's default reserve requirement rates are:

• 0% on negotiable certificates of deposit

• 0% on PASS, IRA, and RCD balances.

• 10% on demand deposits: DDR and DDC. (Note: U.S. reserve requirements on savings accountshave been zero since the Monetary Control Act of 1980. The story for transaction accounts is a bitmore complex. In the early 1980s, Congress decided that each bank should have an exemptionagainst holding required reserves on its first $2 million of transaction balances, and should hold onlya 3% reserve against the next $22 million. These dollar amounts are indexed for the growth rate ofaggregate transaction deposits in the economy. Starting December 26, 2002, the exemption amountstood at $6 million and the low reserve tranche stood at $42.1 million. Unlike ProBanker, the 10%requirement on transaction balances only “kicks in” above this $42.1 million level for each bank.See the Federal Reserve's statistical release notes for reserves and monetary base[http://www.federalreserve.gov/releases/h3/hist/annualreview.htm].)

Your Administrator can change these reserve requirement rates. The current reserve requirements areprovided quarterly in the Economic Environment Report.

You can start to familiarize yourself with the simulation's mechanics by ascertaining that the required re-serves on your starting balance sheet do indeed equal the proper proportion of deposits outstanding.

Each quarter, you should choose an Initial Reserve Allocation sufficient to cover the required reservesimplied by your forecast of reserveable deposit balances. Since even the best forecasts are subject to er-ror, however, your actual Required Reserves (RR) will generally differ from what you had expected.After computing your bank's deposit levels, ProBanker checks to see if you have sufficient reserves:

• If your required reserves are smaller than your Initial Reserve Allocation, the extra funds you had al-located will be invested in a noninterest paying Excess Reserves (ER) account. As explained in Sec-tion 4.5.1.2, ER balances earn implicit interest (which reduces your demand deposit operating costs),at a fraction of the interest payable on federal funds sold. Ideally, therefore, your balance sheet willnever show any ER.

• If RR exceed your Initial Reserve Allocation, some other asset must be sold or liability issued to pro-duce additional reserve balances at the Fed. ProBanker simply allocates sufficient resources to theRR account, and worries about where to obtain those funds later, when it balances the bank's balancesheet. (See Section 4.11.)

Lest you become tempted to let ProBanker worry about your reserve level, note that a transaction cost isassessed for transferring funds into the RR account when the Initial Reserve Allocation is insufficient.(This cost is included in the expense item "Other Transaction Costs".) Accurately setting the Initial Re-


45

http://www.federalreserve.gov/releases/h3/hist/annualreview.htm

serve Allocation requires that you forecast your liability balances for the coming period. While this canbe time-consuming, accurate deposit forecasts permit you to minimize both low-yielding ER balancesand "other transaction costs."


46

Chapter 5. The Effects of YourDecisions

This chapter describes specific effects of the individual decisions you will make each quarter. We pro-ceed in the approximate order that the decisions are presented on the "Game Decisions" page.

To get to the Game Decisions page, go to your Main Page and select either the "Competitive Games" or"Autobank Games" tab. Clicking [Play Game] then takes you to the following page:

Figure 5.1. Game Decisions Page

Note that you are provided with a permissible "Range" for each input value. If you enter a decision out-side this range (e.g. you try to sell more bonds than you own), you will get an error message when youtry to save your decisions. (The "Save" button is at the very bottom of the Game Decisions page, not vis-ible in Figure 5.1.)

When entering your decision, remember to express interest rates in annual percentage form: a 10% an-nual rate is entered as 10.0.

5.1. Quantities to Choose

5.1.1. Initial Reserve AllocationBy regulation, each bank must hold cash or Federal Reserve Bank deposits equal to a certain proportionof its deposit account balances. In ProBanker, as presently in the United States, reserve balances must beat least 10% of all demand deposits outstanding. At the end of each quarter, your bank will show twotypes of reserves: Required Reserves and Excess Reserves. See Section 4.5.1.1 and Section 4.5.1.2.

ProBanker asks you to estimate how much required reserves you will have for the coming quarter. Thisis your "Initial Reserve Allocation." If your Allocation turns out to be insufficient, ProBanker will trans-fer resources from other asset categories. If your Allocation turns out to be too large, the extra reservebalances may be used to finance investments, or they may show up as "Excess Reserve Balances (at oth-er commercial banks)." Section 4.12 explains the process of reserve balancing, and the transaction costsinvolved.

5.1.2. Federal Funds Sold

47

Banks with excess reserve balances can lend them to other banks. When Federal funds are "sold," theselling bank has an asset and the "purchasing" bank has a liability. Most Fed fund loans in the real worldhave a one-day maturity, so you should think of ProBanker as asking you to select an average balance ofFFS for your bank to hold over the coming quarter. See Section 4.5.1.3.

5.1.3. Federal Funds PurchasedFederal funds (or simply "Fed funds") purchased is the opposite of "Federal funds sold". Banks with in-sufficient reserve balances can borrow excess reserves from other banks. "Purchasing" Federal fundscreates a liability on your balance sheet. As with FFS, you should think of this decision entry as the av-erage FFP balance you wish to maintain over the coming quarter. See Section 4.5.2.1.

Negotiable CDs constitute a second source of "purchased money" for your bank, so you should managethese two items in conjunction with one another. (See Section 4.11 and Section 6.1.)

5.1.4. Negotiable CDs To Issue (three maturity choices)Your bank may issue large certificate of deposit (CD) obligations to obtain loanable funds. Usually, youmay issue whatever volume of new CDs you wish, in each of three maturity categories: one, two, or fourquarters. (See Section 4.5.2.3.) The cost of CD funds depends on your firm's leverage: banks with relat-ively low leverage can issue CDs at the (riskless) treasury rate for bonds with the same maturity. Asyour bank's leverage increases beyond some threshold level, however, your required CD rate also rises(Section 4.8). The market may ration your CD issues if you have very high leverage.

5.1.5. New 8-Quarter Bonds To PurchaseBank CEOs may use their loanable funds to make loans or to purchase bonds for their investment ac-count. These bonds are fixed-coupon government bonds. Although they have no default risk, changes inthe level of market interest rates will affect the market value of these bonds. (See Section 4.5.1.8.)

You may purchase only bonds with an initial maturity of 8 quarters (which is the longest maturity inProBanker's horizon). These bonds can subsequently be sold in a perfectly liquid market for a price thatreflects their coupon and current market interest rates.

5.1.6. Bonds to Sell (seven maturity choices)Having purchased some government bonds in an earlier time period, you may now wish to sell them, inorder to make additional loans, to reduce your bank's leverage, or to realize accrued capital gains. (Thedescription of bonds in Section 3.2 describes some of the tax implications of realizing capital gains inthe bank's investment portfolio.) You select which bonds to sell by specifying their maturity date. Gov-ernment bonds may not be sold short.

5.2. Rates to Choose

5.2.1. Fixed Rate Corporate LoansYou specify the (annualized) contract rate of interest to charge on corporate loans with one quarter's ma-turity. This rate should reflect current market interest rates: you should not lend at a rate below yourmarginal cost of loanable funds. (Chapter 6 explains how to compute the marginal cost of loanablefunds.)

5.2.2. Floating Rate Loan Spread

The Effects of Your Decisions

48

Floating rate loans in ProBanker have a maturity of two quarters, and the contract rate is specified as amarkup (or "spread") over an economy-wide "floating rate loan base." This base rate is computed as theaverage of the 90-day CD rate and the period's actual rate on Federal Funds Sold. Ex ante, you shouldexpect that the floating rate loan base will equal the 90-day CD rate, and the Bond Market Report tellsyou what the base rate turned out to be (on average) over the quarter just concluded.

Bank managers specify the spread over this Floating Rate Loan Base at which they are willing to lend.When (if) money market rates change at the start of the next quarter, the contract rate on these loans willadjust by the same amount. Choose your Floating rate spread to cover (at least) your costs of originatingand managing these loans, plus any expected default losses.

5.2.3. Installment Loan RateBank CEOs choose the contract rate to charge on new installment loans, which are made to individualsfor a term of one year. These loans carry a fixed rate of interest, which should reflect your bank's currentcost of 4-quarter loanable funds.

5.2.4. Mortgage Loan RateBank CEOs choose the contract rate to charge on retail mortgage loans that mature in two years. Theseloans carry a fixed rate of interest, which should reflect your bank's current cost of 8-quarter loanablefunds.

Deposit Rate Ceilings

Your Game Administrator can impose a rate ceiling on one or more of the following five de-posit products (retail CDs, passbook, IRAs, and retail and corporate demand deposits). Inform-ation about prevailing rate ceilings is provided in the Economic Environment Report.ProBanker will inform you if your chosen deposit rate violates an operative regulatory ceiling.

5.2.5. Retail CDsChoose the annualized interest rate to pay on these time deposit accounts, which are sold to retail andsmall business customers. The interest rate is fixed for the deposit's six-month term to maturity. YourAdministrator may impose a ceiling on the interest rate you may offer depositors for this type of ac-count, in which case the program will prevent you from entering too high a rate. For technical(programming) reasons, ProBanker does not permit you to enter an annual rate below 0.01%.

5.2.6. Passbook Saving AccountsPassbook accounts -- sometimes called "statement savings accounts" -- are interest-bearing retail depos-its with no specific maturity. Customers can make deposits and (with a few unimportant legal provisos)withdrawals as they wish, and the bank is free to change the rate paid on these balances at the start ofany quarter.

5.2.7. IRA Accounts (Long-term retail time deposits)These are fixed-term deposit accounts much like Retail CDs. IRAs carry a fixed rate of interest and aninitial maturity of two years. Your administrator may impose a ceiling on the interest rate you may offerdepositors for this type of account, in which case the Autobank program will prevent you from enteringtoo high a rate.


49

5.2.8. Demand Deposits (Retail and Corporate)In many countries, banks may pay explicit interest on demand deposit accounts. Although ProBankerprovides for this possibility, the initial situation probably imposes a zero rate ceiling on DD accounts.Once again, permissible DD rates are reported in the Economic Environment Report. You can also seethe currently permissible rates in the "Range" column of the Decisions page.

5.3. Advertising Decisions (seven categories)Advertising or marketing expenditures (expressed in thousands of dollars) can be budgeted to seven in-dividual account categories: retail loans (Home mortgages, Installment loans), retail deposits (Retail DDaccounts, Retail CDs, Passbooks, and IRAs), and to Corporate DD accounts. Advertising expendituresincrease the number of customers (and hence the volume of loan or deposit balances) choosing to dobusiness with your bank at its posted loan and deposit rates. (Section 4.1 explains advertising in slightlymore detail.)

5.4. Capital Structure Decisions

5.4.1. Number of Shares to SellA bank can increase its equity capital account rapidly by selling new shares to the public. (Section 4.10explains how shares are valued.) It can also return capital to its owners by repurchasing shares in thepublic market. To retire (repurchase) shares, enter a negative number for "Number of Shares to Sell."ProBanker will not let you repurchase more shares than you have outstanding.

Manage your equity capital by selling (repurchasing) shares and by varying your cash dividends.

5.4.2. Total DividendsYour shareholders are anxious to receive a return on their invested capital, and paying them a high,steady dividend rate will raise your stock price. Dividend payments also affect your leverage: you canincrease (reduce) your bank's Net Worth by paying cash dividends lower (higher) than your net income.You should manage dividends in conjunction with your decisions about selling or re-purchasing sharesin the market.

5.5. Other (Miscellaneous) Decisions

5.5.1. Provision for Loan LossesAs explained in Section 4.6, LLA changes through time as

LLAt = LLAt-1 + PLLt - (Actual Losses)t.

where PLL is the "Provision for Loan Losses." As realized loan losses deplete the LLA, bank managerscharge an expense item (PLL) each quarter to restore the allowance account. Your regulator requires thatyou maintain a LLA equal to a fixed proportion of your current nonperforming loans. Initially, this pro-portion is 100%, but your Administrator can change this requirement. The applicable proportion is re-ported near the bottom of the Economic Environment Report.)

The Provision for Loan Losses cannot be a negative number. Therefore, if you make an excessivelylarge Provision one quarter, you cannot quickly reverse it the following quarter.


50

5.5.2. Corporate Loan StandardA bank can decide how stringently to set its underwriting standards for corporate loans (FR, FL). Ahigher loan standard means that your bank will suffer fewer credit default losses. At the same time,however, you will have lower loan balances at any given loan rate because fewer loan applicants satisfyyour credit standards. (See Section 4.6.1) The same underwriting standard applies to both fixed andfloating rate corporate loans.)

Enter a "+1", "0", or "–1" for a "high," "normal," or "low" credit standard. While you may enter anynumber between –1 and +1, the program will round it to the nearest integer (–1, 0, +1).

5.5.3. Percentage of Cost Charged to Demand Deposits(Retail and Corporate)

Most banks charge explicit fees to cover their cost of providing transaction services to DD customers.You may specify what proportion of your retail and corporate DD operating costs to collect from cus-tomers in the form of fees charged. For example, if annual retail DD operating costs were 3% of bal-ances and you set your fees at 66% (entered as "0.66"), your net cost of maintaining retail demand bal-ances would be 1% per year (3%*(1-.66) = 1%). If you charged fees of "160", you would more than re-cover your cost of providing DD services. With this fee, you would be making a profit of 1.8% per yearon your DD balances.

So, why not just set high fees? Because high fees are equivalent to "paying negative interest", which re-duces the attractiveness of your deposit accounts. Other things the same, higher fees result in lower DDbalances. (See Section 4.5.2.2.)


51

Chapter 6. Analyzing Your Bank'sCondition and Making Good Decisions

How well are you serving your shareholders? Remember that they have committed some of their invest-ment capital to your care, and your job is to return profits to them. How much profits? There are twoways to look at this. First, shareholders could always purchase long-term government bonds -- so theirreturn from holding equity in your bank should at least exceed that rate! The second perspective is just adifferent facet of the first: unless the market value of bank equity exceeds the value of capital paid in byyour shareholders, they would have been better off investing their funds in fairly-priced market invest-ments. If your ROE or market value of equity is low, you particularly need better decisions (and perhapsa better decision-making process) to improve your bank's profitability.

This chapter provides some analytical tools and techniques for evaluating your ProBanker decisions.Each of the following sections (Section 6.1 through Section 6.5) is self-contained, so there is no "cor-rect" order in which to read them.

6.1. Pricing Rate-Set Assets and LiabilitiesOne of ProBanker's biggest challenges is to set profitable interest rates on your Rate-Set assets and liab-ilities. Essentially, you need to decide:

• Do you want a large loan volume at a low contract rate, a low loan volume at a high rate, orsomething in between?

• Do you want a low deposit volume at a low contract rate, a high deposit volume at a high rate, orsomething in between?

You should choose the price-quantity combination that maximizes the profits you derive from each loanor deposit segment. We have prepared a separate document, ProBanker Economics Lesson: How toMaximize Bank Profits, which describes optimal profits in terms of the marginal cost of deposits and themarginal return on loans.

Financial accounting systems don't report marginal costs or revenues, but only averages. Fortunately,you can make a really good start on maximizing profits by simply avoiding one simple mistake:

Don't lend money for less than it costs you to borrow.

Obvious, you say? Sure, but sometimes it is hard to put this obvious dictum into practice. Managers canwind up lending money at a lower return than their cost of funds in three general ways:

• Be surprised by the increases or decreases in the level of market (bond) interest rates.

• Set a deposit rate that fails to recognize all the costs of servicing depositors.

• Set a loan rate that fails to recognize the operating costs and default losses associated with those bor-rowers.

The remainder of this section shows you how to avoid these potential traps.

6.1.1. Obtain Adequate Loanable FundsProBanker managers often earn low profits because they have not obtained sufficient funds to financethe bank's loan book. In the financial markets, you can borrow funds at the Federal funds or negotiableCD rates. You can also finance loans by liquidating part of your government bond portfolio. However, ifyou leave your bank short of loanable funds, you must use Discount Window Advances, and they can be

52

very expensive. We have seen many ProBanker banks for which the extra (penalty) interest paid onDWA more than offsets all the profits from the rest of the balance sheet.

Conclusion: a successful bank manager cannot rely on DWA for funding. Be sure you understand Sec-tion 4.11 and implement adequate funding policies.

6.1.2. The All-Inclusive Cost of Deposits and Other LiabilitiesIt is tempting to think of a bank's liability cost as simply the explicit interest it pays to its creditors.However, taking in bank deposits requires three additional costs

• unreimbursed costs of servicing liability-side customers,

• advertising to attract new deposit customers, and

• deposit insurance premia (FDIC).

How can we combine all these costs into a single, "all-inclusive" cost of deposit funds?

We seek an all-inclusive cost of deposits, but some of our expenses are expressed as an annual rate ofinterest (e.g. the explicit rate paid), and other expenses are provided as a quarterly dollar expenditure.To combine these pieces of information, first express each dollar cost as a proportion of deposit bal-ances, then convert those expense proportions to annual rates.

6.1.2.1. Annualizing Operating Expenses

For simplicity, we will treat all operating costs as if they are strictly proportional to the associated ac-count balances. The fee income on DDR and DDC should be treated as a negative cost.

Start with the easiest cases: Negotiable CDs and Federal Funds Purchased, which incur noninterest oper-ating expenses only when they are initially set up on the balance sheet. The maturity of these liabilitiesdetermines the impact of operating expenses on the cost of funds. Assume that a 4-period, $1,000 Nego-tiable CD costs $1 to negotiate and book. Once you have obtained these funds, they stay with you for afull year. So the annualized operating cost of this Negotiable CD is ($1 / $1,000) = 0.1%.

What if the Negotiable CD's maturity were only two quarters, instead of four? Then you would have toissue another 2-Period CD six months from now in order to keep that source of funds for one year. Theannualized noninterest cost of this rollover strategy is thus $2 per year per $1,000, or 0.2%. What calcu-lation would you make for a 1-period CD or for FFP?

Unlike these perfect market liabilities, most loans and deposits incur operating costs throughout theirlife. Loan customers require continual monitoring and deposit customers use their accounts to pay bills,transfer funds abroad, etc. Approximate your quarterly rate of operating costs for each account as a per-centage of the dollar balances. Then multiply this rate by 4 to convert to an annual cost.

6.1.2.2. Annualizing Advertising Expenses

Think of your advertising expenditures as the cost of attracting a new account, whose funds remain withyou for a fixed amount of time: 2 years for IRAs, one-half year for Retail CDs and so forth. The cost ofadvertising should therefore be amortized over the length of time that the newly attracted funds will re-main at the bank, then annualized.

Let's take four-period installment loans. Suppose you spent $100 on their marketing campaign and at-tracted $10,000 in new INST loan balances. This amounts to a 1% cost of getting these loans onto yourbooks. Once there, they stay for a full year. So the annualized cost of attracting these loans is also 1%.

Example: You spent $200 advertising for two-period Retail CDs and attracted new balances of $30,000.Advertising thus cost you 0.667% of the balances attracted. Since these deposits mature in 6 months,

Analyzing Your Bank's Condition and MakingGood Decisions

53

you will have to advertise again to obtain a full year's worth of Retail CD funding. Hence, the annual-ized cost of Retail CD advertising is 1.33%.

6.1.2.3. The All-in Cost of Deposit Funds

You now have three types of deposit costs, each expressed as an annual percentage rate: the explicit in-terest rate paid, the annualized operating expense, and the annualized advertising expense. The cost ofdeposit funds is simply the sum of these three items.

6.1.2.4. The Effect of Reserve Requirements

Reserve requirements force banks to hold sterile vault cash or deposits at the Federal Reserve Bankequal to some fraction of their deposit liabilities. This need to hold sterile reserves drives a wedgebetween deposit balances and loanable funds. Reserve requirements raise a bank's cost of funds, and areeffectively an excise tax on deposits.

Suppose that the reserve requirement on a particular deposit type is k, meaning that the bank must holdcash assets equal to a fraction k of its deposit balances. The bank may lend only (1-k) dollars out of eachdeposit dollar, even though it must pay interest on the full deposit dollar. That is, "loanable funds" (LF)equal only a fraction of deposits:

LF = (1-k)D

(Loanable funds are the dollars a bank can use to purchase productive assets, after setting aside its re-quired cash reserves.) The cost of loanable funds is then given by:

RLF = Rd/(1-k).

Now, we reiterate and demonstrate the proper way to combine operating costs, advertising, and reserverequirements in computing the full cost of various deposit accounts.

6.1.2.5. Example #1: Computing the All-Inclusive cost of Retail CDs

Suppose:

• Your Balance Sheet Report shows your bank paid explicit interest of 5.65% last quarter on new Re-tail CDs of $126,426.69.

• Your Income Statement shows Retail CD operating expenses were $752.57 for the total balances of$301,028.12, or 0.25%. Since these expenses recur each quarter, the annualized operating expense is1.0%.

• Your Income Statement shows that the advertising expense to attract that new money was $1,150, or0.91% of the $126,426.69 that was newly deposited during the most recent quarter.

• Because Retail CDs have a maturity of two quarters, this advertising expense will have to be re-peated once more in order to secure funds for a full year -- which means that the annualized ad costof obtaining Retail CD balances was 1.82%.

• You pay an FDIC insurance premium on Retail CD balances. The size of this assessment can be cal-culated by dividing the FDIC Insurance Premium Expense (found on the Income Statement report)by the total amount of deposits (found on the Balance Sheet). Since this is an expense incurred eachquarter we multiply it by four to obtain 28 basis points per year.

The all-inclusive cost of Retail CD deposit funds is the sum of these four expenses:

Explicit Interest Rate Paid 5.65%

Annualized advertising costs 1.82%


54

Annualized operating costs 1.00%

Annual FDIC premium assessment 0.28%

Total: annual cost of Retail CD deposit funds 8.75%

Note that the all-inclusive cost of Retail CD funds exceeds the Explicit Interest Rate Paid by more than200 basis points.

6.1.2.6. Example #2: The All-in Cost of Negotiable CDs

Now perform similar computations for a second type of deposit, Negotiable CDs. Suppose:

• The explicit rate paid on 4-quarter CDs was 5.28%.

• The balance sheet shows a total of $1,250,000 in Negotiable CDs.

• The income statement shows an operating cost of $440 for Negotiable CDs.

What is the appropriate deflator for this quarterly operating cost? From examining the Decision EntryForm for this quarter (not shown), we can see that the bank issued a total of $400,000 in new negotiableCDs (of all maturities) in the last period. Since CD operating costs occur only when new securities aresold, the proportional cost of selling these CDs was 0.11%.

• You must also pay FDIC insurance premia on large CD balances. This premium was computed inExample #1 as 0.28% per year.

• The annualized cost of 4-period CDs is then 5.28 + 0.11 + 0.28 = 5.67%.

• Just for this example, assume a required reserve ratio of 3% on Negotiable CDs. The annual cost ofloanable funds from 4-quarter CDs is thus (5.67%)/(1-0.03) = 5.85% per year.

If the above negotiable CD had a 2-quarter maturity and everything else were unchanged, the annualizedoperating cost of these deposit funds would be 0.22% (rather than 0.11%), making the annualized cost of2-period CD funds = (4.99 + 0.28 + 022)/(1-0.03) = 5.66%.

2-Quarter CD 4-Quarter CD

Explicit Interest Rate Paid 5.28% 5.28

Annualized advertising costs --- ---

Annualized operating costs 0.22% 0.11%

Annual FDIC premium assessment 0.28% 0.28%

Total: annual cost of CD deposit funds 5.78% 5.67%.

Annual cost of Loanable Funds (with a 3% re-serve requirement)

5.96% 5.85%

OK, now that you know your all-inclusive cost of funds for each liability, what good is it? Well, thesimplest idea is that you should not pay more for funds from one source than it would cost to obtainmore funds from another. For example, you can get 1-Period funds from DDR, DDC, passbooks, FFP,or 1-period Negotiable CDs. If one of these is a lot cheaper than the others, reduce your use of the relat-ively expensive source of funds.

6.1.3. The Net Return on Loans and Other AssetsManagers set a contract interest rate for each type of loan. The net return on an asset equals its contractrate, less

• its associated operating costs,


55

• any advertising expenses aimed at those specific loan customers, and

• expected default losses.

Once again, we can compare different assets more easily if we express dollar-denominated costs as aproportion of outstanding balances. Because explicit interest rates on the bank's assets and liabilities areexpressed as "9.5% per year", we should convert the associated noninterest expenses into an annualizedproportion of loan balances. You do this exactly the same way for loans as you did for deposit liabilitiesin Section 6.1.2 above.

The annualized noninterest costs and advertising expenditures should be subtracted from the contractloan rate. For example, if it costs you $1.60 per year to service $200 in loans, and you are paid 9.5% in-terest on those loans, the total net return from those loans 8.7% (=9.5% - (1.60/200)). If you advertisedfor these loans, their net return would be even lower.

The new wrinkle with loans is that we must also subtract expected default losses in order to compare theprofitability of different assets. You can forecast future default losses from current nonperformance ra-tios, but you must properly annualize these predicted loss ratios. Once again, maturity dictates the properway to annualize. We provide specific numbers by assuming that we are managing the New World Ban-corp, Ltd., described in Table 6.1 (this table is repeated from Table 4.2).

Table 6.1. Loan Performance Report






Fixed Rate 170,345.14 147.46 0.09 0.14 208.58

Floating Rate 277,296.45 522.05 0.19 0.30 1,311.55

Installment 90,377.41 710.16 0.79 0.98 3,441.84

Mortgage 55,552.30 39.11 0.07 0.10 417.75

Totals 593,571.31 1,418.78 5,379.72

Consider first FL loans, whose maturity is two quarters. The Loan Performance Report indicates that0.30% of the FL balances are nonperforming. We know that about 75% of nonperforming loans eventu-ally default at maturity (see Section 4.6), which implies that about 0.225% of FL principal will not be re-paid at maturity. Since the FL portfolio turns over twice per year, its annual losses will be 0.45% of av-erage FL balances outstanding -- 0.225% losses per loan times two turnovers of the loan portfolio annu-ally. After removing the effect of operating costs, the annualized loan rate charged on FR should there-fore be at least 0.45% above riskless market rate. If it is not, the bank could do better by investing ingovernment bonds.

How about fixed-rate Corporate Loans (FR), which remain outstanding for only one quarter? The LoanPerformance Report indicates that 0.14% of one-period FR loans are nonperforming, so we expect three-quarters of these (about 0.105%) to default at maturity. Since four successive FR loans will come dueeach year, the annual losses on all FR loans will be 0.42% of the average balances outstanding.

The final two loans types are 8-Period mortgage loans and 4-Period installment loans. Unlike CorporateLoans, managers may advertise for these accounts. Examples #3 and #4 illustrate the appropriate calcu-lations.

6.1.3.1. Example #3: The Net Return on Mortgage Loans


56

Suppose that:

• The explicit interest rate charged on new MORT was 8.00%, and the new MORT loan balance was$107,004.85.

• The Loan Performance Report indicates that 0.10% of all MORT balances are now nonperforming.We therefore expect that 0.075% (75% of the nonperformers) will default at maturity - and a defaul-ted loan returns exactly nothing to the lender in ProBanker.

• Mortgage loans have a maturity of two years, so the annualized expected default loss on MORT is0.0375%.

• The income statement show that $80 of advertising expense was directed at new MORT borrowers.This advertising expense amounts to 0.0748% of the new loan volume ($107,004.85), and it securesinterest-earning loans for two years. Therefore, the annual advertising cost required to attract onedollar of mortgage loans is half of 0.0748% = 0.0372%.

• Assume that our balance sheet and income statement show operating expenses were $1,674.20 forthe total MORT balances of $455,671.40. This comes to 0.37% per calendar quarter, or 1.48% peryear.

Expected losses and expenses must be subtracted from the contract rate on MORT in order to produce anet annual return:

MORT contract rate (gross) 8.00%

Expected annual defaults (0.04%)

Annualized advertising expenses (0.04%)

Annualized operating costs (1.48%)

Net MORT return 6.44%

6.1.3.2. Example #4: The Net Return on Installment Loans

Consider the effect of setting the contract rate on new INST loans at 9.0%.

• The Loan Performance Report (Table 6.1) indicates that 0.98% of the bank's Installment loans arenow nonperforming. Since expected future default losses equal 75% of nonperforming loans, wepredict (guess) that about 0.735% of Installment loans will not repay. Since the maturity of INSTloans is one year, this is the annual default rate we expect on the INST loans.

• Assume we have a balance sheet and income statement showing advertising expenses of $170 andnew INST loan volume of $138,771.38. It thus cost 0.1225% of the new loans to attract them intothe bank. Since INST have a one-year maturity, 0.1225% is also the annualized advertising expense.

• Further assume that our (imaginary) balance sheet and income statement show operating costs of$4,277.20 for total INST outstanding of $395,879.00. Since these expenses will recur each quarter,the annualized operating cost is (4*(1.07%)) = 4.28%.

INST Contract rate (gross) 9.00%

Expected annual defaults (0.74%)

Annualized advertising costs (0.12%)

Annualized operating expenses (4.28%)

Net INST return 3.86%

What a difference between the gross and the net returns! In this light, 9% does not look like a very highcontract rate.


57

OK, so what should you do with this information about net asset returns? Compare them to one another!If two assets with similar maturity have different expected returns, get rid of the low-yielding one anduse the proceeds to buy more of the higher-yielding one.

You should also make cross-balance sheet comparisons: if 4-period deposits cost you a total of 7.5% andINST loans have 3.86% net return, you need to raise the contract rate on INST loans! Sometimes peopleare afraid that they'll "lose market share" if they raise their rate. So what? When you are losing moneyon each dollar lent, reducing your market share is a good idea, not a bad one.

6.2. Managing Interest Rate RiskSince interest rate changes are difficult to forecast accurately, leaving your bank's profits dependent onrate changes exposes you to uncontrollable external influences. Most of the time, therefore, bankers tryto limit the impact of interest rate changes on their income and/or equity market value.

Your Administrator or textbook may have spent a lot of time discussing interest rate risk (IRR) expos-ure. We discuss one simple method for keeping track of your bank's (IRR) exposure -- maturity gap ana-lysis. Most other, more sophisticated tools for measuring interest rate risk are grounded in some type of"gap table," which sorts balance sheet items according to when their principal repayments occur.

The appropriate maturity bucket for each balance sheet item corresponds to the time at which the prin-cipal amount will either repay or re-price. Some items (such as DD and PASS) have no specific matur-ity. Their proper treatment is tricky, but we discuss it briefly in Section 6.3.

Table 6.2. Maturity Gap Worksheet

End of Quarter Number _____

Principal Repricing at the start of Quarter Number ...

T+1 T+2 T+3 T+4 Later

Assets

* Careful here ... think about it.

Required Reserves

Federal Funds Sold

Fixed Rate Corp. Loans

Floating Rate Corp. Loans*

Retail Installment Loans

Mortgages

Bonds

Fixed Assets

Liabilities

Federal Funds Purchased

Retail Demand Deposits*

Corp. Demand Deposits*

Negotiable CDs

Passbook*

Retail CDs

IRAs

Discount Window Advances


58

A Maturity Gap Table like Table 6.2 provides some rough information about a bank's IRR exposure.The underlying idea is that all dollars in the same "maturity bucket" reprice at the same time and by thesame amount. You can then hedge your income stream by keeping your gaps -- especially the longer-term ones -- close to zero.

The effective maturities of some balance sheet items in ProBanker substantially exceed their stated ma-turities, because customer relationship effects make customers slow to switch banks even when marketrates change. You should make some sort of adjustment to your Maturity Gap Table to incorporate thiseffect.

The Gap Table can serve as input to "duration" calculations that measure the impact of market ratechanges on your bank's equity market value. Duration calculations also incorporate more informationabout the present interest rate environment, which may enhance the accuracy of your computed IRR ex-posures.

You can download all your bank's data as a csv file ("comma-separated-values", see Section 2.5) andbuild a maturity gap table with which to analyze your own bank's risk exposure.

6.3. Customer Relationships and Effective Maturit-ies

A perfect-market security's effective maturity exactly equals its stated maturity: when a perfect-marketsecurity matures, it will be replaced only if its coupon rate fully reflects current market conditions. Forexample, no bank can issue new Negotiable CDs are any rate below the current market rate, and this rateis the same for all (riskless) banks in the economy.

By contrast, some customers with established banking relationships are reluctant to change bankswithout good cause. These individuals will "roll over" their time deposits at the same bank even if thatbank's rate is slightly below the rate available "across town." (This is rational for depositors who facecosts of switching to a different bank.) Similarly, loan customers are already known to their bank, andwill find it cheaper to re-apply for a new loan at their old bank even if that bank's loan rate is somewhathigher than the rate available elsewhere.

What is the maturity of a demand deposit?

Demand deposit balances may be withdrawn at any time without advance notice or penalty, butcustomers tend to keep positive DD balances even when market interest rates are very high.The effective maturity of these DD balances depends upon how much (and how quickly) de-positors adjust their average account balances in response to market interest rate changes. If de-positors never adjusted - that is, if they kept the same account balance regardless of interest ratelevels - DD would be a perpetual, fixed-rate liability for the issuing bank. More realistically,average DD balances tend to move inversely with market interest rates. When market rates rise,the bank loses some DD balances.

Although the details are complex and hard to estimate precisely, the general implications forIRR management are clear: in measuring your bank's IRR exposure, be careful to distinguishbetween nominal and effective account maturities.

In general, customer relationships mean that allocating deposit and loan balances to their stated maturitybucket in Table 6.2 will not reflect your bank's true interest-rate risk exposure. Even if your bank doesnot fully respond to market rate changes, some of your customers will renew their loans or deposits. InProBanker, the importance of these relationships varies across products. As in the real world, customerrelationships are most important for demand deposits (DDR and DDC) and PASS, because small cus-tomers are less inclined to search for new alternatives than larger customers are. Bankers generally ad-


59

just their initial Maturity Gap Tables to "spread" DD and PASS balances over a number of maturitybuckets, rather than assuming that all these balances will immediately leave the bank if rates elsewhererise relative to the rate being paid here.

6.4. Managing Your Capital RatioSection 4.9 describes the capital adequacy regulations governing your ProBanker bank, and the Regulat-ory Environment Report provides current information about the applicable minimum capital ratios. Yourbank's capital ratios (measured as both "leverage" and a "risk-based capital" constraint) must be man-aged carefully for two reasons.

• If regulators find you operating with excessive leverage, they force a stock sale, which the market re-ceives very poorly. Investors pay 20% less for new stock than they would if the bank voluntarilybrought the same issue to market.

• Large depositors and investors begin to worry about a bank's credit condition when its leveragepasses some threshold level. (Managers do not know this critical leverage level precisely, but it islower than the level at which regulators intervene to raise new equity.) The higher your leveragerises above this threshold, the higher will be your cost of FFP and Negotiable CDs, and the lowerwill be your supply of DDC. For banks with very high leverage, the rate on FFP and Negotiable CDsreaches an upper bound, and the market begins to ration its supply of uninsured FFP and CDs. In thiscase, a bank might ask for $100 million of FFP, but receive less -- say $75 million. This fundingshortfall is made up at the discount window.

In managing your bank's capital adequacy, remember that the relevant variable is a ratio. You can raiseyour capital ratio by either raising the numerator (Net Worth) or lowering the denominator (Total orRisk-Weighted Assets). You can increase Net Worth by issuing new shares or paying lower dividends.You can lower your bank's assets by selling off your bond portfolio, holding fewer FFS investments, orraising you loan rates to reduce loan volumes. (Lowering your capital ratio requires that these actions bereversed: repurchase stock, increase dividends, buying bonds, etc.) However, if your capitalization re-port indicates that you have violated the supervisory minimum capital standards, your only choice is tosell new shares -- immediately!

Each possible means of changing leverage may affect your current shareholders' wealth. For example:

• Selling new shares requires an investment banking fee (which is effectively paid by your old share-holders) and dilutes your original shareholders' stake in the firm.

• Lowering dividends tends to depress your stock price slightly, as investors become less certain thatthey will earn cash flows from the firm.

• Reducing asset size by raising your loan rates may move you away from the profit-maximizing loanvolume, thus reducing your profits.

One (surprisingly common) situation permits you to raise profits and lower leverage at the same time: ifyou are carrying perfect-market assets whose net return lies below the all-inclusive cost of any perfect-market liability, you should eliminate both securities from your balance sheet. It's not very often thatyou get to kill two birds with the same stone!

6.5. Estimating the Rate-Sensitivity of Loan De-mands and Deposit Supplies

Caution

This Section explains how to apply two key concepts to your pricing decisions marginal depositcost and marginal loan revenue. The main theoretical ideas are discussed in ProBanker Eco-


60

nomics Lesson: How to Maximize Bank Profits, which you can download from the Web site.This material is more difficult than in the rest of Chapter 6, and your Administrator may notwant you to spend time on it. Therefore, consider Section 6.5 optional, and don't approach ituntil you have learned to avoid the more basic obstacles to profitable operations.

There are two main rules for maximizing profits from imperfectly competitive loans and deposits.

• Select loan rates so that the marginal revenue on loans equals the marginal cost of your loanablefunds.

• Select deposit rates such that the marginal cost of loanable funds equals either the government bondrate or the cost of perfect-market liabilities (CDs or FFP).

Some Definitions

The marginal cost of deposits is your cost of raising an additional dollar of deposit balances.The marginal cost has two components. First, it includes the rate that you pay to the "marginal"(that is, the additional) depositor. Second, since all depositors are paid the same rate, you mustalso account for the additional interest paid to your "infra-marginal" (that is, previous) deposit-ors. The marginal cost of deposits is always at least as great as the deposit rate being paid.

Loanable funds. We defined this concept in Section 6.1. To review: reserve requirements causea distinction between deposit balances and loanable funds. Loanable funds are the dollars youcan lend when you issue more of some liability.

The marginal revenue from a particular type of loan is the total interest revenue gained by mak-ing an additional, one-dollar loan. The marginal revenue has two components. First, it includesthe interest you receive from the "marginal" borrower. Second, since all borrowers are chargedthe same loan rate, you must also take into account the lower interest payments that you will re-ceive from your "infra-marginal" borrowers. The marginal revenue on loans can never be great-er than the loan rate being charged.

The main challenge to applying these rules in ProBanker comes from estimating each Rate-Set Ac-count's marginal cost or revenue. Account types differ in their sensitivity to interest rates, reflecting thefact that different types of customers have different alternative sources of financial services. (SeeChapter 4.) A manager cannot rationally price Rate-Set loans and deposits without some sense abouthow sensitive each account type is to changes in market rates--both her own and those of her competit-ors.

How can you estimate the elasticity of these accounts? ProBanker provides you with two general meansof estimating account rate sensitivities: a "quick and dirty" method from the Competitive Mode, and amore precise method using Autobank. Whichever method you use, though, remember that your estim-ated elasticity may be quite inaccurate. Don't be too discouraged by this state of affairs -- even an impre-cise estimate is much better than no estimate at all!

6.5.1. Slope Estimates from Competitive Mode OutputsThe Full Balance Sheet Report shows both rate and quantity for each account type at "This Bank," andat the "Average Bank in This Market." Table 6.3 offers a sample.

The last row in Table 6.3 indicates that your bank paid 4.55% for $72,339.64 of new IRA funds, whilethe average bank in the market paid 5% for $84,574.58. You can use these two rate-volume combina-tions to identify two points on the same deposit supply (or loan demand) schedule. By plotting thesepoints and assuming (counter-factually, as it turns out) that the demand (supply) schedule is linear in theposted rate, you can estimate how sensitive fund balances will be to changes in one bank's posted rate.


61

Table 6.3. Excerpt from Full Balance Sheet

This Bank This Market

Amount Rate Amount Rate

IRAs, maturing start of:

Quarter T+1 37,043.69 7.50 37,043.69 7.50

Quarter T+2 ...

...

Quarter T+7 90,249.63 6.25 52,069.70 5.22

Quarter T+8 72,339.64 4.55 84,574.58 5.00

Figure 6.1. Estimated Supply Curve for IRA Balances

What is the slope here? It appears that this bank can attract $12,234.94 additional IRA dollars by paying45 basis point more. So the slope is $27,188.76 per percentage point of deposit rate paid.

Figure 6.1 provides only a rough approximation to ProBanker's true economic structure. Since it incor-porates only two data points, the implied slope will be pretty "noisy." Moreover, your reports provide noinformation about your competitors' advertising rates or fees. You can improve your slope estimates asthe Competitive simulation proceeds by combining data points from more than one quarter. However,government bond rates change over time and you must somehow incorporate that information into yoursensitivity estimates. Finance theory suggests a reasonable solution to this problem:

Borrowers and depositors react to the differential between your bank's rate and the rate on a similar-maturity government bond. For example, suppose the 8-period bond rate associated with Table 6.3 was5.5%. Then "This Bank" got $72,339.64 of deposits when it paid "-95 basis points" (4.55% - 5.50%),and the average bank in "This Market" attracted $84,574.58 by paying "-50 basis points." By plottingyour balances and your average competitor's balances against the difference between the deposit's ratepaid and the bond rate, therefore, you should get a more stable estimated schedule than if you plot theabsolute level of rates.

An even more important concept is the marginal cost of the funds that would be raised by paying 5% in-stead of 4.55%. Table 6.4 shows how to calculate this marginal cost. Column (3) is simply the productof columns (1) and (2). Column (4) measures the change in total interest cost between the two adjacent


62

deposit rates, and column (5) shows the corresponding change in dollar balances. Dividing the change ininterest cost (column (4)) by the change in deposit volume (column (5)) yields column (6): the marginalcost of funds over this portion of the deposit supply schedule. Raising the IRA deposit rate from 4.55%to 5% will raise new funds at an approximate cost of 7.66% -- plus any additional costs due to advert-ising or operating expenses, of course.

Table 6.4. Marginal Cost Estimates for IRA Balances, using Competitive Modeoutput

Explicit Volume Annual Change in Change in Marginal

Rate at End of Interest Interest Deposit Explicit

Paid Quarter #4 Cost Cost Volume Interest Cost

(1) (2) (3) (4) (5) (6)

4.55% $72,339.64 $3,291.45

$937.28 $12,234.94 7.66%

5.00% $84,574.58 $4,228.73

6.5.2. Slope Estimates from Autobank OutputsAutobank permits you to develop more accurate estimates of your customers' rate sensitivities by "re-running" history with only one item changed - the rate you are paying on one deposit product or the rateyou are charging on one loan product. (Section 2.7 explains how to re-run history.) Each time you re-runhistory in Autobank, market interest rates evolve along the same path, GDP grows at the same rate, andyour bank is affected by the same random factors. Because your Regional competitors' behavior is pre-programmed, it also remains the same across multiple simulations. While the elasticities estimated fromAutobank are not perfectly applicable to the Competitive Mode, they provide a good indication of howmuch more deposit (loan) balances you can attract by varying your posted rates.

The first two columns of Table 6.5 were generated by this repetitive simulation technique.

1. Input an initial rate for the Retail CD accounts into Autobank's Decision Entry Form (7.00% in Ta-ble 6.5).

2. Simulate four successive quarters with the same set of Decisions, to get an idea of the chosen rateslong-run effect on Retail CD balances.

3. Record the volume of Retail CD balances at the end of Quarter 4.

4. Reset Autobank to its initial state (see Section 2.7), choose a new Retail CD rate (8.00% in Ta-ble 6.5), and go to Step 2 above.

As in Table 6.4, we then computed the marginal cost of funds over the indicated deposit-rate intervals.

Assuming that the deposit supply curve is linear, the data in Table 6.5 imply the marginal explicit in-terest cost schedule plotted in Figure 6.2. (As it turns out, ProBanker's supply and demand schedules forRate-Set items are not linear. Absent specific information about the functional form, however, most ana-lysts would appeal to Occam's Razor and assume linearity, at least for a start.) Remember that column(6) shows only the marginal explicit interest cost, which omits advertising, fees, operating costs, FDICinsurance, and reserve requirements. Your pricing should reflect all these items.

From these simulations, we see that the Marginal Explicit Interest Cost rises from 11.2% (when the Re-tail CD rate is 7%) to about 15% (when the Retail CD rate is 10%). To cover bank operating costs(assume that these cost about 1% annually) and FDIC insurance (28 basis points per year) we must addabout 1.28% to the Table's estimated marginal costs.


63

Table 6.5. Marginal Cost Estimates for Retail CD Balances, using AutobankMode output

Explicit Volume Annual Change in Change in Marginal

Rate at End of Interest Interest Deposit Explicit

Paid Quarter #4 Cost Cost Volume Interest Cost

(1) (2) (3) (4) (5) (6)

7.00% $89,608 $6,273

$3,125 $27,866 11.2%

8.00% $117,474 $9,398

$3,879 $30,043 12.9%

9.00% $147,517 $13,277

$5,283 $38,080 13.9%

10.00% $185,597 $18,560

$6,933 $46,156 15.0%

11.00% $231,753 $25,493

Figure 6.2. Marginal and Average Costs of Retail CDs

How should we choose the best rate to offer these depositors? Maximum bank profits occur when itequates the marginal liability cost to the marginal asset return. In ProBanker's multiple-maturity envir-onment, apply this rule to each available maturity of liabilities and assets.

For example, you have two possible sources of 2-quarter loanable funds: Retail CD and 180-day negoti-able CDs. Suppose the negotiable CDs have an explicit interest cost of 14.32%, an annual operating costof .22%, an annual FDIC insurance premium (28 basis points) and are subject to a 3% reserve require-ment. (The actual reserve requirement on large CDs is 0%. We include a positive reserve requirement inthis calculation only to make the example more general.) Then the all-in cost of loanable funds obtained


64

from issuing 180-day negotiable CDs is:

RCD = (14.32%+0.22%+0.28%)/(1-.03) = 15.278%.

This calculation indicates that you can obtain more 2-period money in the Negotiable CD market at15.278%. You should therefore issue Retail CD until the marginal, all-inclusive cost of loanable fundsobtained from this source is also 15.278%, or when the marginal explicit interest cost is about 14.0%.Table 6.5 indicates that this marginal interest cost corresponds to a deposit rate of between 9% and 10%,so a Retail CD rate in that range will maximize your profits from this funding source.

Note that advertising on Retail CDs was not considered in the preceding calculations. It would requireanother set of experiments to determine what combination of advertising and explicit interest will raisethe highest amount of Retail CD for an average cost of 9% or 10% (which is the approximate rate atwhich the marginal cost of Retail CD equals the cost of loanable funds from 180-day CDs).

In concluding this discussion, we would like to emphasize that you cannot obtain a perfectly accuratemeasure of your bank's various interest sensitivities. Unlike textbook problem sets, real-world managersnever know all the facts they need! Financial tools and analysis are your only guide to good business de-cisions, even when you must work very hard to get mediocre estimates of the relevant parameters.

Welcome to real-life finance!


65

Appendix A. Answers to FrequentlyAsked Questions

Despite our best efforts, this Players' Manual probably does not explain every item to every reader'scomplete satisfaction. This chapter provides further clarification for some of the questions that havebeen asked most frequently while using ProBanker in undergraduate and MBA classes, and in interna-tional executive programs.

This chapter contains little information that is not provided elsewhere in this manual, but the fact that theinformation is organized differently might make it easier for you to find what you need to know. Thequestions are not presented in any particular order, so read through them all to be sure you understandProBanker's operations. If you are interested in a particular item, try searching for it in your downloadedmanual, using the Adobe Acrobat's "Find" feature.

Good luck!

A.1.How can I get Help while I am working on the ProBanker web site?

The Players' Manual is provided to you in both HTML and pdf format. (Click "Help" on the leftside of your Main Page to view the HTML and/or download the pdf.) You can print a hard copy ofthe manual from the pdf file, which is about 100 pages long. You can also open the pdf version inAdobe's Acrobat Reader™, and use Acrobat's "Find" feature to search for specific terms or topics.

Paid players can surf the HTML version of the Players' Manual online.

A.2.What happens if my decisions are submitted just a little bit late for the Competitive Mode simula-tion?

In the Competitive Mode, each bank's results depend on the decisions of all its Regional competit-ors. It is therefore imperative that each bank has timely decisions recorded at the ProBanker website. If a bank fails to enter decisions, its decisions from the preceding quarter are repeated. If thefailure to enter decisions occurs in the first simulated quarter, ProBanker inserts pre-specified loanrates and zero deposit rates, which are likely to be highly unprofitable. These unusual rates willalso make it harder for your competitors to manage their banks properly. Please be careful to sub-mit your quarterly decisions in a timely manner.

A.3.Can I get information about my bank any way besides the Standard Reports?

Sure, but it requires some knowledge of a spreadsheet program like Excel™. The lower right-handcorner of the Reports page permits you to "Download CSV." A CSV file ("comma separated val-ues") is a standard way to export data from one program (E.g., ProBanker) to another (e.g.,Excel™). The exported file contains your bank's entire history. Your Administrator may havesome Excel™ worksheets that generate certain reports. If not, drop us a note at [email protected] [mailto:[email protected]].

A.4.I got carried away (having fun) and simulated all 50 quarters for which ProBanker has storagespace. What can I do now?

Autobank can store only 50 simulated quarters' results, of which one is the bank's initial condition("Quarter No. 0"). But you can always reset Autobank to its condition at any prior quarter. The

66



quickest way to get back to Quarter #0 is to make a new Autobank from the Template you used tocreate this one.

A.5.I entered the interest rate on fixed rate loans as 9%, but it showed up on my reports as 0.09%.What happened?

ProBanker expects that the loan and deposit rates will be entered as annual percentages. Thus,"nine percent" should be entered as 9.00.

A.6.Some of my balance sheet (income statement) items have entries composed entirely of 9's. Whatdoes this mean?

If a player's decisions have generated a dollar volume or interest rate that cannot be stored in theallotted disk space, that value is replaced with a field of 9's. This will only occur if a bank's ratesare very different from its competitors'. The bank's reported balance sheet will not balance pre-cisely in this case, but you can continue making new decisions for subsequent quarters.

A.7.I have forgotten the password I need to sign on to ProBanker. Who can help me?

Your Administrator can obtain your password using his or her software. (Tell him to click "ViewPlayers" and then click on your username.) You can also send an email to [email protected] [mailto:[email protected]] from the same email address that youhave on file with us. We'll get back to you as soon as we can, but it might take 24 hours. So tryyour Administrator first.

A.8.How can I "turn back time" in Autobank Mode?

Sometimes it can be very helpful to "re-run" history as part of a sensitivity analysis, or to "turnback time" in order to correct a mistake you made in an Autobank game. (Your Administrator hasa similar power in Competitive games, but you will almost never be affected by this develop-ment.) To restore your Autobank game to its condition one quarter ago, go to the very bottom ofyour "Game Decisions" screen (shown in Figure 5.1) and click on [Back 1 Quarter]. To moveback more than one quarter, just repeat this procedure as many times as you need. Note that onceyou "go back" in time, it's pretty easy to move forward again. Since your old decisions remainstored, all you need to do is "simulate" to move one period toward the present time. Usually,though, the reason for moving back in time is to change one or more decisions, so you can seetheir effects.

A.9.I wanted to sell $50 million in new 1-period negotiable CDs, but ProBanker issued $50 billion in-stead, sending my leverage through the roof! What happened?

ProBanker expresses all dollar amounts in thousands of dollars. If you want to issue $50 millionin new liabilities, enter "50,000" on the Decision Entry Page.

A.10.When I run Autobank, my Balance Sheet shows two identical pairs of columns. What's up?

In Autobank Mode, your bank is the only active competitor (the other banks are pre-programmedautomatons). Hence, you are the "Average Bank" in your Region. In the Competitive Mode, the"Average Bank" columns of the balance sheet show the average of all active banks in the Region(including yours).

A.11.

Answers to Frequently Asked Questions

67



How long will my Autobank keep simulating?

ProBanker can presently maintain up to 50 simulated quarters. Within those quarters, you can go"Back 1 Quarter" at a time to re-run a past quarter with different decisions. If you get to the 50thquarter, go back to the Template from which you created your bank, and convert it into a newAutobank. You then have 50 more quarters to work with.

A.12.We are now running in Competitive Mode. I've made some decisions, and would like to simulatetheir effects before submitting them to my administrator. How can I do that?

Unfortunately, you cannot do this. ProBanker keeps track of your Competitive Mode results inone set of data files, and stores any Autobank results in a separate set. Because these two files can-not be combined, you cannot "test drive" your Competitive decisions by running them throughAutobank. Autobank doesn't "know" about your Competitive Mode bank's condition. Even if youcould enter those decisions to a similar Autobank, the pre-programmed competitors in Autobankwould almost surely not behave the same as your Competitive rivals.

A.13.What is the purpose of my "Initial Reserve Allocation?"

Because you cannot control your liability balances precisely, you do not know exactly how muchreserves you will need. One of your quarterly decisions is an "Initial Reserve Allocation" whichyou believe will be sufficient to cover your required reserves. Any unneeded funds from the InitialReserve Allocation are invested in demand deposit balances at other commercial banks, earning arelatively low level of implicit interest. (See Section 5.1.1.) Hence, in order to avoid having anyexcess reserves, you should set your Initial Reserve Allocation as low as possible. However, if thisallocation is lower than your Required Reserves (RR) turn out to be, you will be charged a trans-action cost for the service of fulfilling this reserve requirement. You should therefore choose anInitial Reserve Allocation above your forecast of RR, but not too much above.

A.14.I have noticed that the amount I request for FFP and FFS do not always get provided on my finalbalance sheet. Why not?

Both FFP and FFS play an important role in making sure your bank's assets equal liabilities plusnet worth. (In other words, these two items serve as important "plug" variables.) If your decisionsleave you with insufficient funds to honor all of your loan and investment commitments, FFS willbe lowered from your initially chosen level to free up funds for use elsewhere on the balancesheet. Similarly, if you are awash in funds, ProBanker invests all of the unneeded funds in FFS.Section 4.11 provides details.

A.15.I understand that I shouldn't pay more on retail deposits than the rate at which I can purchasemoney in the wholesale market with FFP or Negotiable CDs. But how do I choose an appropriatedeposit rate?

At the optimal deposit rate, the marginal cost of a dollar raised from each type of retail depositsshould equal the marginal cost of a dollar raised in the wholesale money markets for the samelength of time. This means that you must compute:

• The marginal annual explicit interest cost of each deposit type. (This procedure is illustrated inSection 6.5.)

• The annualized marginal operating cost, which is equal to the average operating cost inProBanker. See Q: A.17.


68

• The annualized marginal advertising cost. See Q: A.16 below.

The sum of these marginal costs should be compared to the cost of loanable funds (explicit in-terest plus operating costs, adjusted for reserve requirements) on a similar-maturity negotiableCD.

Choosing a "similar maturity" is tricky because retail deposits are substantially influenced by cus-tomer relationship effects. That is, the effective maturity of retail deposits can exceed their nomin-al (stated) maturity by a considerable amount. Even though this is a subtle effect and there is noeasy way to derive the exact result, we feel that the issues are still worth raising. Also, IRA ac-counts have a stated maturity of 8 quarters, and there is no negotiable CD with this maturity.Hence, players should compare the all-inclusive cost of loanable funds from IRAs against the8-period government bond rate -- which measures your bank's marginal revenue on 8-period in-vestments.

A.16.How can I properly annualize advertising expenses?

See the advertising example in Section 6.1.2.2.

A.17.How about the proper way to annualize operating costs?

Discussed, with examples, in Section 6.1.2.1.

A.18.How should I annualize the rate of expected loan losses?

Section 6.1.3 discusses how to use the information in the "Loan Performance Report" to computeannualized expected loan losses. It also explains how to incorporate expected default losses intothe loan contract rate.

A.19.What's the best way to succeed at managing my bank?

Spend some time at the start to be sure you understand how ProBanker works. (Read this manual;experiment with Autobank.)

Be sure that your loan rates cover your marginal cost of funds plus expected defaults and the oper-ating costs generated by new loans. In other words, lend only at rates that provide a net rate of re-turn above your borrowing costs.

Be sure that your "all inclusive" marginal cost of loanable funds obtained from retail deposits (i.e.,the explicit rate, plus advertising, plus operating costs, plus the FDIC insurance premium) is nohigher than the cost of "buying" funds through Fed funds or negotiable CDs. If you're unsureabout marginal costs, at least be sure that your average net loan rate covers your average "all in-clusive" cost of funds.

Carefully forecast your bank's balance sheet items to avoid being forced to borrow at the DiscountWindow. If you are having trouble staying away from the Discount Window, borrow a big chunkof FFP as a cushion.

Pay attention to market interest rates and implied future rates from the term structure when decid-ing how to fund your asset portfolio.

Keep track of your capital ratio. Sell stock yourself, rather than having regulators do it for you.


69

Keep track of your bank's interest rate risk exposure using a maturity or duration gap system.

A.20.At the end of last quarter's report, the 1-period bond rate was 8.43%. I had expected to pay thisrate for new negotiable CDs. But my report for this quarter says that the rate on my outstanding1-period CDs is 8.87%. What happened?

There are two possible explanations for this result. First, your bank may be so highly levered thatinvestors require a default risk premium on uninsured liabilities. (See Q: A.21.) Second, if yourleverage is not too large, the answer lies in the way your CD liabilities are recorded on the balancesheet. The volume of CDs due to mature in the coming period is the sum of three items: 4-periodCDs issued three periods ago, 2-period CDs issued last period and 1-period CDs issued in the cur-rent period. The rate on the Balance Sheet Report is a blended rate, equal to a weighted average ofthe rates on those three components.

A.21.How can I tell if my bank is so highly levered that I am paying a default premium on uninsured li-abilities?

Compare the rates for Federal Funds Purchased vs. Federal Funds Sold. If your borrowing rate(FFP) exceeds the lending rate (FFS), investors are charging you a default risk premium. Thispremium increases with the liability's maturity. In addition, if your corporate demand depositorshave fears about your financial stability, you will have smaller DDC balances for any effective in-terest rate, the higher is your leverage. (You cannot directly observe the DDC effect, but it isthere.)

A.22.It seems that no matter what I try, my bank always loses money. How can I make a profit?

You should be able to earn positive profits in ProBanker, although it is tough to produce consist-ently large ROE. When a player is regularly suffering large losses, her basic analysis of break-even loan and deposit rates is often at fault. Review Chapter 6 to be certain that your loan rates arehigh enough and your retail deposit rates are low enough. Another common cause of large lossesis reliance on the (very expensive) Discount Window for financing. ProBanker usually charges ahigh penalty rate for Discount Window borrowing, to provide players with appropriate incentivesto plan for their cash needs. (The Economic Environment Report indicates the penalty rate youradministrator has set for your economy.) If you have been borrowing at the Discount Window, re-examine Section 4.11 and Section 6.1.1.

A.23.How does ProBanker compute my LLA?

Credit losses are deducted from the loan loss allowance (LLA) as they occur, and players mustenter an expense item "Provision for Loan Losses" (PLL) to augment the allowance account. TheLLA at the end of Quarter t is thus determined as:

LLAt = LLAt-1 - (Actual default losses during quarter t) + PLL

Regulators will sometimes adjust your LLA. If the LLA falls below a fixed proportion of non-performing loans, ProBanker automatically moves funds from Net Worth into the LLA. (The lastsection of the Economic Environment Report tells you this proportion.) These funds are recordedon the income statement as "Provision for Loan Losses", and you pay an "Other Transaction Cost"because you did not make adequate provision yourself. The Other Transaction Cost is proportionalto the funds moved.

A.24.How and when does the regulator force a sale of stock? Why shouldn't I let her do it for me?


70

At the start of each simulated quarter, ProBanker pays dividends and executes any stock transac-tions specified by the CEO. The regulator then checks whether each bank's current Net Worth sat-isfies the capital adequacy requirements described in the Economic Environment Report. If capitalis inadequate, regulators force the bank to sell additional stock, but this does not serve your share-holders well: when regulators have forced a stock sale, the market pays only 80% of what it wouldpay for a voluntary stock sale.

Managers should anticipate their bank's capital needs by carefully comparing Capitalization Re-port information against the required capital information in the Economic Environment Report.

If your bank's end-of-period capital ratios are below their required levels, sell enough new sharesto restore your capital to a regulator-approved level.

A.25.I specified that I wanted to purchase (that is, to borrow) $300 million from the Federal Funds mar-ket. I got it all, but still ended up borrowing from the Discount Window. Why?

DWA is used to balance the balance sheet only when you have committed to fund assets in excessof your available loanable funds. Obviously, $300 million was not enough inter-bank borrowings,given your bank's other commitments. ProBanker imposes a substantial penalty on banks that bor-row from the Discount Window in order to give you an incentive to worry about adequately fund-ing your bank.

Before making your next set of decisions, write down explicit forecasts for each Rate-Set item onyour balance sheet. Then be sure that your overall sources of funds at least equal your planneduses. When you get back your results, compare actual deposit and loan volumes to your forecasts,to determine which forecasts were least accurate.

One ready way to avoid the Discount Window is to specify a very large volume of FFP, of whichthe excess will be lent out as FFS. While this solution will (almost surely) keep you out of the Dis-count Window, it requires you to pay a "round-trip" transaction cost on a large volume of FedFunds (see Section 4.11). It also raises your Total Assets, which puts pressure on your capital ra-tios. (See Q: A.24.)

A.26.How can I use the market interest rates reported in my Bond Market and my Bond Portfolio Re-ports?

These market rates on government bonds play several roles.

• They are the yields to maturity on bonds you may be holding in your portfolio.

• They indicate the rate you will pay on negotiable CDs issued at the start of the next period(unless your bank is highly levered).

• The average interbank (Fed Funds) rate expected to prevail in the coming quarter equals the1-period bond rate in these reports. (The actual Fed Funds rate will generally differ from itsexpected value.)

• They serve as important reference points for your Rate-Set pricing decisions. (See Q: A.15 andSection 6.1.)

• The floating rate loan base is an average of the 1-period bond rate and the average Fed Fundsrate.

• Nominal GDP grows at an annual rate approximately equal to the yield on 90-day governmentbonds.

Today's market interest rates summarize the market's expectations about future rate levels, and


71

therefore indicate how future interest rates are most likely to change.

A.27.How do the end of period ‘T' and the start of period ‘T+1' line up in time?

The balance sheets produced by ProBanker mostly describes the last instant in Period T. The bal-ance sheet shows a number of asset and liability items whose principle will be repaid at the firstinstant of Period T+1. The funding decisions you are making must therefore take account of assets(FFS and other assets "maturing at the start of quarter T+1") and Liabilities (FFP, DWA, and de-posits "maturing at the start of quarter T+1") that are about to be repaid. See Section 3.3 and Fig-ure 3.1.

A.28.How can I possibly estimate what my fixed rate loan balances will be next period?

Your question reflects a concern with the important issue of how to balance your balance sheet.First of all, remember that many loan and deposit products exhibit slow adjustments due to cus-tomer relationship effects. As a result, next period's loan balance will be fairly close to last peri-od's balance unless you or your competitors change pricing sharply, or if market interest rateschange.

What if you expect a sharp pricing change? The Autobank Mode can help you make good fore-casts. Liberal experimentation with alternative pricing policies in Autobank will indicate whichRate-Set items are most sensitive to changes in their contract rate of interest.

Another source of data for estimating elasticities comes from the quarterly Balance Sheet reportsproduced in Competitive Mode. These reports show "This Bank's" rate and quantity, and the rateand quantity for the "Average Bank in This Market." These two observations represent two pointson (approximately) the same demand or supply schedule. As a crude approximation, assume thatthe demand or supply schedule is linear, and plot two data points from the same simulated quarter,with different posted loan rates.

In addition, the demand for loans (supply of deposits) depends largely on the differential betweenthe loan (deposit) rate and the market rate on similar-maturity government bonds. This permitsyou to estimate elasticities from many different simulated periods, each with a different level ofmarket interest rates.

A.29.I don't seem to have enough information to apply (such-and-such) a tool, which we discussed atsuch length, and with such precision, in class. What should I do?

Welcome to the real world, where you are often forced to apply tools and to make decisionswithout full information (or at least without the information being provided in the standard text-book fashion). Make a forecast ("guess"). Do the best you can. Use the analytical techniques youhave learned to the greatest extent possible, and try to figure out how confident you should be inthe resulting "answers."

A.30.How and when are asset principal amounts repaid?

ProBanker assets and liabilities pay interest quarterly, and principal at maturity.

A.31.How can I predict loan defaults?

Some proportion of last period's nonperforming loans will default at maturity. Your Loan Per-formance Report provides information on both nonperforming and defaulted loan balances, so you


72

can estimate their relationship from that Report. (Its default value is 0.75 but, as usual, your ad-ministrator can change this proportion.) Multiplying this expected value by the volume of loansdue to mature in the coming period will give the expected dollar value of defaults. Actual losseswill vary from this expectation due to changes in GDP, changes in the level of market interestrates, and other random factors.

A.32.In setting my loan rates, how much should I add to my cost of loanable funds to cover expecteddefault losses?

Convert the "Fraction Now Non-Performing" percentages in the Loan Performance Report intoexpected quarterly loss rates, as described in the preceding question. Then convert your estimatedloss percentages to annual rates, as described in Section 6.1.3. Your loan rate should exceed yourcost of loanable funds by at least the annualized loss rate on your invested funds (plus operatingcosts for that loan type).

A.33.Explain ProBanker's timing. What point in time does the balance sheet describe?

The balance sheet applies to the last instant in Quarter T (which was just simulated). As such,items "Maturing at the start of Quarter T+1" will mature in the first instant of the coming period.(At the time you are making your decisions, these items have a duration/maturity of effectivelyzero). This convention is necessary because the balance sheet would not generally balance if weremoved the imminently maturing assets and liabilities.

Income and expenses reported to you have been accrued through the end of Quarter T. See Sec-tion 3.3 and Figure 3.1.

A.34.How can I avoid borrowing at the Discount Window, which carries a large penalty rate?

There is no way to assure that your bank will not borrow from the Discount Window. However,carefully forecasting your bank's likely asset and liability flows will allow you to provide ad-equate resources to fund asset commitments. If you enter a somewhat-too-large value for inter-bank borrowings, this may generate some extra transactions costs or leverage costs, but will helpkeep you out of DWA. See also Q: A.24.

A.35.How do I sell specific bonds out of my portfolio?

At the end of each quarter, the final column of the Bond Portfolio Report lists the bonds you cur-rently own. Meanwhile the Decision Entry Form for the upcoming quarter permits you to selectappropriate bonds to sell. ProBanker will not let you sell bonds that you do not own. For example,suppose at the end of quarter 3 that bank holdings are $14,750 for bonds due at the start of quarterT+5 (that is, the start of quarter 8). Then your largest possible sale of bonds due in quarter T+5will be $14,750. You are not allowed to have negative bond balances.

A.36.The way ProBanker computes operating costs seems so complicated! Is there an easy way to ap-proximate these costs?

Table 4.1 describes your bank's cost structure, which is indeed complex. To simplify cost estima-tions for the Rate-Set items, assume that all costs are proportional to the balances outstanding, asin Section 4.3.

Then you can reasonably approximate the true operating costs (at least in most "usual" circum-stances) by dividing the cost item by the outstanding volume of the asset or liability. In most


73

cases, the relevant dollar volume is the sum of multi-period balance sheet items: two FL volumes,all eight MORT volumes, etc.

For the Quantity-Set items, costs generally accrue only when the liability is initially issued orwhen the asset is initially purchased. In these cases, the transaction cost rate equals the reportedoperating cost divided by the volume of bonds bought and sold, or new CDs issued. The interbankborrowing items (FFS and FFP) are more complex because your requested volumes may not sur-vive the process of balancing your balance sheet. The relevant volume of interbank borrowingsand placements is the sum of initial decisions plus any subsequent reductions in interbank place-ments that occurred because the bank was initially under-funded. See also Q: A.14.

A.37.I raised my loan rate a lot, and the volume fell off very, very sharply. Why?

While it is logical that your loan value would fall as you raise you loan rate, yon have discovereda feature of the adjustment mechanism for Rate-Set assets and liabilities. So long as your bank'sloan rate stays within a certain proportion of the break-even rate, a sluggish ("partial adjustment")mechanism determines your actual loan volume by averaging the prior period's loan volume andthe "long run" volume associated with the current pricing environment. (See Section 4.2.)However, when your loan rate is more than a certain percentage above its break-even level, thepartial adjustment mechanism recedes and your loan volume jumps immediately to its long runlevel. This simulates your customers' shock and dismay that you would try to exploit their loyalty!Players whose loan volume has dropped to such a low level will find it difficult and expensive tore-build their loan volume quickly.

Deposit volumes are determined similarly: when your deposit rate drops sufficiently far below itsbreak-even level (at which the average cost of deposits equals the similar-maturity bond rate), thepartial adjustment mechanism recedes and your deposit volume jumps immediately to its long runlevel.

A.38.How can I make profits by issuing negotiable CDs to finance my bond portfolio?

There are really two answers to this question. The first is that the all-in cost of negotiable CDswill always exceed the net return on similar-maturity government bonds, because of transactioncosts, reserve requirements, and the deposit insurance premium. Simultaneously holding 1-periodor 2-period bonds and CDs must lower your profits.

However, you can reasonably finance long-term bonds with short-term CDs under several circum-stances.

• First, you may be holding long bonds to hedge a net short asset position elsewhere on yourbalance sheet.

• Second, you may be speculating that market rates will fall, in which case the long-term bondsallow you to lock in today's relatively high yields.

• Finally, you may believe that the term premium in longer-term bond rates is sufficient to coverthe otherwise negative spread. Of course, the expected profit must compensate for the termstructure risk associated with such a "borrow short, lend long" strategy.

A.39.How large should my advertising expenditures be?

First, be clear about how to compare advertising expenditures to the explicit rates you set: convertyour advertising expenses into annualized percentages, as described in Section 6.1. Second, Sec-tion 4.1 states that some limited amount of advertising expenditure has a greater impact on cus-tomer behavior than a similar amount spent by the bank on direct interest reimbursement. Use


74

Autobank to experiment with different combinations of advertising and explicit interest, to seehow much advertising in fact is more productive than simply raising explicit rates on deposits orlowering contract loan rates.

Aside: ProBanker includes advertising in order to provide you with the opportunity to managetwo different types of expenditure on loan and deposit customers:

• The contract interest rate, which makes your interest costs vary proportionally with the out-standing balances.

• Advertising, which is fixed in dollar terms and which players should therefore vary as the ac-count volume changes over time.

A.40.My MORT rate wound up far below those of my regional competitors, which made my new mort-gage loan volume much larger than I had forecast. I was therefore forced to borrow from the Dis-count Window, at a large penalty rate, and I lost a lot of money this past quarter! How can I limitthe volume of new business my bank takes on?

You cannot impose specific limits on your bank's new business volume. Rather, you must makesure that your loan rates are reasonably well related to the cost of funds, your operating expenses,and the optimal profit margin. This should keep your loan rates generally in line with Regionalcompetitors' to prevent the problem from recurring. Unfortunately, you are stuck with those newmortgage loans for another seven quarters, so find a cheap way to finance them!

A.41.How can I determine if my bank's profits (or its market value) will rise or fall if interest rateschange unexpectedly? In other words, how can I assess my bank's interest rate risk exposure?

This is a very important question, to which there is no easy answer either in ProBanker or in thereal world. To understand the basic concept of Interest Rate Risk (IRR) exposure, think of yourbank's equity as a leveraged claim on a portfolio of bonds. (From a finance perspective, loansclosely resemble bonds.) Your profits are roughly equal to the spread between interest earned andinterest paid. If a bank's borrowings and assets have equal sensitivities to market rate changes, thisspread will be unaffected by interest rate changes. Both revenues and costs will change, but theireffects on profits will offset one another. By contrast, if you have "borrow short and lend long"positions, a market rate increase will drive up your interest costs faster than your revenues, mak-ing your profits fall. The opposite occurs if you have "borrowed long and lent short."

In computing the duration (interest sensitivity) of your bank''s equity, we must recognize that thenet effect of a change in market rates has two parts: its effect on bank profits and its effect on therate at which those profits are discounted. Since the appropriate discount rate generally moves inthe same direction as riskless bond rates, a bank's equity market value will be inversely related tothe level of market rates unless its liabilities have longer maturity (duration) than its assets. Eventhen, however, equity may be negatively related to interest rates: profits must rise by enough tooffset the increased discount rate.

A number of considerations complicate this simple view of bank IRR exposure. First, some bankcosts are not proportional to liabilities. In addition, a growing proportion of banks' total profitscome from noninterest sources, including deposit fees, which are not very interest sensitive (or, atleast, their interest sensitivity differs from that of interest expenses). Finally, banks have numerous"off balance sheet" positions that affect their overall IRR. In ProBanker, for example, the custom-er relationships on rate-set loan and deposit accounts generate rents (excess profits) whose presentvalue tends to move inversely with market interest rates (which discount the profit cash flows).Valuable customer relationships thus make your bank more negatively affected by rate increases(and positively affected by rate decreases) than a simple maturity gap table would indicate. Sec-tion 6.2 discusses these issues.

A.42.


75

What are the advantages of being in a Region with fewer competitors?

None! Each bank has the same basic demand curve for loans and supply curve for deposits, re-gardless of how many competitors operate in the Region, so the number of competing banks inyour Region has no direct effect on your ability to attract business. While a larger Region may bemore likely to include aggressive competitors, their effect on you would be greater in a smallerRegion. In short, your Region's size per se has neither clear advantages nor clear disadvantages.

A.43.Where can I find information about the regulatory constraints to which my bank is subject?

ProBanker produces an Economic Environment Report, which lists current:

• Minimum capital ratios

• Reserve requirements

• Deposit rate ceilings

• The FDIC insurance premium

• Minimum LLA requirement

• Income and capital gains tax rates.

A.44.I asked ProBanker to let me issue $75 million in 4-period negotiable CDs, but my balance sheetshows only $53 million were issued. What happened?

Unless your bank is very highly levered, you will successfully issue all the perfect market liabilit-ies (FFP and Negotiable CDs) you specify. As your leverage increases beyond some critical value,however, you will be required to pay a default risk premium on these liabilities (see Section 4.8and Q: A.20 above).

Once the required default risk premium gets to a second critical value, investors will refuse to pur-chase all of the FFP or Negotiable CDs liabilities you would like to sell. At a very high leverageratio, you will be able to sell no new uninsured claims. This reflects the real-world tendency ofuninsured claimants to run against (i.e., withdraw their funds from) banks that are suspected of be-ing near insolvency. Since you will already have committed yourself to purchase specific assetsby the time the market decides to ration you, ProBanker forces you to borrow funds from the Dis-count Window instead of obtaining them from the market (see Section 4.8).

A.45.How can I predict future interest rates in ProBanker?

Bankers and other institutional investors spend considerable resources trying to predict the courseof future market interest rates (government bond yields). In ProBanker, government bonds evolveaccording to the Modified Expectations Hypothesis. The present term structure of spot interestrates implies a set of forward rates that can be used (with some manipulation and some informa-tion about the magnitude of term premia) to predict future interest rates. If your textbook doesn'tcover the term structure of interest rates (also called "the yield curve"), download ProBanker Fin-ance Lesson: The Term Structure of Interest Rates from our Web site.

A.46.I was studying the Economic Environment Report, and discovered some deposit rate ceilings ofmore than 9,000%. What does that mean?

The game Administrator can impose deposit rate ceilings on some of your bank's accounts, and


76

some of those ceilings are expressed (to him/her) in terms of a spread below Treasury bond rates.In order to omit rate ceilings from these accounts, the Administrator sets this spread to a largenegative number (-99.9), which ProBanker takes to mean that you can set your deposit rate up to9,990% above the similar-maturity treasury rate. Effectively, no rate ceiling applies on such an ac-count.

A.47.How does ProBanker compute the cost of managing my Federal Funds position?

Because the actual volume of FFS and FFP can depart from what you initially requested (seeQ: A.14), ProBanker may undertake some FFS/FFP transactions for you. For example, if you spe-cify FFS = $100 million, but ProBanker finds that it needs $40 million of this to satisfy loan de-mand, your bank has effectively lent $100 million, then borrowed back $40 million, for a totaltransaction volume of $140 million. Your bank is charged a transaction cost on all these federalfunds transactions, despite the fact that you had initially requested only $100 million and ended upwith only $60 million in FFS.

A.48.I specified on the Decision Entry Form that I wanted my PLL expense to be 2,000, but the IncomeStatement Report shows that the actual expense was 3,289. What happened?

Regulators require that your LLA equal at least some minimum proportion of your nonperformingloans. (This required proportion is shown in the Economic Environment Report). If your end-of-quarter LLA is too small, the program automatically transfers reserves out of the NW accountas PLL. (See Section 4.6.3.) In the case you describe, the program transferred an additional 1,289to the LLA in order to fulfill this regulatory requirement. You were also charged an "Other Trans-action Cost" proportional to the amount of funds transferred.

A.49.Where do the rates on my Negotiable CDs come from?

That depends. If your bank is not excessively levered, your CD rates equal the riskless rates ongovernment bonds with the same maturity. If your bank IS excessively levered, investors demanda rate premium above these riskless rates as compensation for the possibility that you will default.Finally, remember that the rate on 1-period and 2-period Negotiable CDs may be a blended rate.For example, the 1-period CD rate reported on the Full Balance Sheet might be an average of therate on new 1-period CDs you just issued and the rate on 4-period CDs that you issued three peri-ods ago.


77

Appendix B. Sample Reports for theRegional Low-Cost Template after Q0B.1. Summary Balance Sheet


Player: Jane Doe

Summary Balance Sheet Report: Quarter 0

Proportion

of Total

ASSETS

Required Reserves (at the Federal Reserve) 27,569.69 1.83%

Excess Reserve Balances (at other commercial banks) 0.00 0.00%

Federal Funds Sold 0.00 0.00%

Fixed Rate Corporate Loans 145,384.09 9.65%

Float Rate Corporate Loans 370,241.80 24.57%

Installment Loans 364,003.24 24.15%

Mortgages 403,221.71 26.76%

Bonds 180,000.00 11.94%

Fixed Assets 21,739.00 1.44%

Loan Loss Allowance 5,206.84 0.35%

Total Assets 1,506,952.71 100.00%

LIABILITIES

Federal Funds Purchased 35,000.00 2.32%

Retail Demand Deposits 151,812.76 10.07%

Corporate Demand Deposits 123,884.19 8.22%

Negotiable CDs 200,000.00 13.27%

Passbook Deposits 87,609.03 5.81%

Retail CDs 328,997.10 21.83%

IRAs 320,816.49 21.29%

Discount Window Advances 121,791.43 8.08%

Net Worth and Retained Earnings 137,041.72 9.09%

Total Liabilities and Net Worth 1,506,952.71 100.00%

B.2. Balance Sheet

78


Player: Jane Doe

Balance Sheet Report: Quarter 0



ASSETS

Required Reserves (at the Federal Re-serve)

27,569.69 27,569.69

Excess Reserve Balances (at othercommercial banks)

0.00 0.00

Federal Funds Sold 0.00 4.23% 0.00 4.23%

Fixed Rate Corporate Loans 145,384.09 9.30% 145,384.09 9.30%

Floating Rate Corporate Loans, maturing start of:

Quarter T+1 182,454.31 4.00% 182,454.31 4.00%

Quarter T+2 187,787.49 4.00% 187,787.49 4.00%

Retail Installment Loans, maturing start of:

Quarter T+1 102,459.22 11.00% 102,459.22 11.00%

Quarter T+2 68,109.35 11.00% 68,109.35 11.00%

Quarter T+3 114,773.41 11.00% 114,773.41 11.00%

Quarter T+4 78,661.26 11.00% 78,661.26 11.00%

Retail Mortgage Loans, maturing start of:

Quarter T+1 83,347.96 9.00% 83,347.96 9.00%

Quarter T+2 59,327.68 9.00% 59,327.68 9.00%

Quarter T+3 48,013.08 9.00% 48,013.08 9.00%

Quarter T+4 31,836.82 9.00% 31,836.82 9.00%

Quarter T+5 52,000.78 9.00% 52,000.78 9.00%

Quarter T+6 49,882.89 9.00% 49,882.89 9.00%

Quarter T+7 40,177.78 9.00% 40,177.78 9.00%

Quarter T+8 38,634.72 9.00% 38,634.72 9.00%

Bonds, maturing start of:

Quarter T+1 22,500.00 22,500.00

Quarter T+2 22,500.00 22,500.00

Quarter T+3 22,500.00 22,500.00

Quarter T+4 22,500.00 22,500.00

Quarter T+5 22,500.00 22,500.00

Quarter T+6 22,500.00 22,500.00

Quarter T+7 22,500.00 22,500.00

Quarter T+8 22,500.00 22,500.00

Fixed Assets 21,739.00 21,739.00

Loan Loss Allowance 5,206.84 5,206.84

Total Assets 1,506,952.71 1,506,952.71

LIABILITIES

Federal Funds Purchased 35,000.00 4.23% 35,000.00 4.23%

Sample Reports for the Regional Low-CostTemplate after Q0

79


Player: Jane Doe

Balance Sheet Report: Quarter 0



Demand Deposits:

Retail 151,812.76 0.00% 151,812.76 0.00%

Corporate 123,884.19 0.00% 123,884.19 0.00%

Negotiable CDs, maturing start of:

Quarter T+1 50,000.00 5.23% 50,000.00 5.23%

Quarter T+2 50,000.00 5.23% 50,000.00 5.23%

Quarter T+3 50,000.00 5.23% 50,000.00 5.23%

Quarter T+4 50,000.00 5.23% 50,000.00 5.23%

Passbook Savings Deposits 87,609.03 5.00% 87,609.03 5.00%

Retail CDs, maturing start of:

Quarter T+1 152,883.06 6.00% 152,883.06 6.00%

Quarter T+2 176,114.03 6.00% 176,114.03 6.00%

IRAs, maturing start of:

Quarter T+1 40,414.56 7.50% 40,414.56 7.50%

Quarter T+2 37,358.71 7.50% 37,358.71 7.50%

Quarter T+3 39,336.77 7.50% 39,336.77 7.50%

Quarter T+4 39,996.59 7.50% 39,996.59 7.50%

Quarter T+5 44,973.25 7.50% 44,973.25 7.50%

Quarter T+6 41,311.88 7.50% 41,311.88 7.50%

Quarter T+7 40,381.04 7.50% 40,381.04 7.50%

Quarter T+8 37,043.69 7.50% 37,043.69 7.50%

Discount Window Advances 121,791.43 9.23% 121,791.43 9.23%

EQUITY CAPITAL

Net Worth and Retained Earnings 137,041.70 121,791.43

Total Liabilities and Net Worth 1,506,952.71 1,506,952.71

B.3. Income and Expense ReportBank: Regional-Low Cost Template

Player: Jane Doe

Income and Expense Report: Quarter 0

Proportion

of Total

CURRENT REVENUE

Fee Income


Corporate Demand Deposits 464.57 1.35%


80


Player: Jane Doe


Proportion

of Total

Interest Income

Fixed Rate Corporate Loans 3,377.25 9.83%

Floating Rate Corporate Loans 7,594.80 22.11%

Installment Loans 9,911.89 28.85%

Mortgages 9,063.59 26.38%

Bonds 2,803.50 8.16%

Federal Funds Sold 0.00 0.00%

Short-term Gain from Bonds 0.00 0.00%

Total Revenue 34,354.19 100.00%

CURRENT EXPENSES

Interest Expense

Federal Funds Purchased 370.13 1.18%


Retail Demand Deposits 0.00 0.00%

Negotiable CDs 2,615.00 8.31%

Passbook Deposits 1,095.11 3.48%

Retail CDs 4,934.96 15.69%

IRAs 6,015.31 19.12%

Discount Window Advances 2,810.34 8.93%

Provision for Loan Losses 821.72 2.61%

Advertising

Installment Loans 240.00 0.76%

Mortgages 130.00 0.41%

Retail Demand Deposits 630.00 2.00%


Retail CDs 400.00 1.27%

Passbook Deposits 210.00 0.67%

IRAs 100.00 0.32%

Other Noninterest Operating Costs

FDIC Insurance Premium 849.18 2.70%

Federal Funds 38.50 0.12%

Fixed Rate Corporate Loans 290.77 0.92%

Floating Rate Corporate Loans 740.48 2.35%

Installment Loans 1770.66 5.63%

Mortgages 600.61 1.91%

Bonds 45.00 0.14%




81


Player: Jane Doe


Proportion

of Total

DD Costs Offset by Excess Reserves 0.00 0.00%

Negotiable CDs 55.00 0.17%

Passbook Deposits 114.14 0.36%

Retail CDs 469.32 1.49%

IRAs 401.02 1.27%

Fixed Operating Costs 3,099.61 9.85%

Other Transaction Costs 154.26 0.49%

Total Expenses 31,459.94 100.00%

Net Current Operating Earnings 2,894.24

Taxes on Current Earnings 1,012.98

Realized Capital Gains 0.00

Taxes Applicable to Capital Gains 0.00

Total Taxes 1,012.98

Total Net Income 1,881.26

B.4. Capitalization ReportBank: Regional-Low Cost Template

Player: Jane Doe

Capitalization Report: Quarter 0

Current Preceding

Quarter Quarter

Price Per Share 60.48 51.47

Market Value of Equity 60,484.86 51,466.40

Book Value of Equity 137,041.72 137,041.72

Number of Shares Outstanding 1,000,000 1,000,000

Number of Shares Sold by Management 0 0

Price 0.00 0.00

Number of Shares Sold by Regulators 0 0

Price 0.00 0.00

Dividends Paid 0.00 0.00

Net Total Assets 1,506,952.71 1,610,238.86

Risk-weighted Assets 1,102,979.00 1,198,656.50

Basel Tier I Ratio 12.42 11.43

Basel Tier I+II Ratio 12.90 11.92

Capital/Asset Ratio 9.09 8.51


82

B.5. Loan Performance ReportBank: Regional-Low Cost Template

Player: Jane Doe




Fixed Rate 162,854.16 140.98 0.09 0.14 199.41

Floating Rate 235,626.98 443.60 0.19 0.30 1,114.46

Installment 101,749.76 799.00 0.79 0.98 3,570.95

Mortgage 53,193.62 37.42 0.07 0.10 395.57

Totals 553,424.52 1,421.00 5,280.39

B.6. Bond Portfolio ReportBank: Regional-Low Cost Template

Player: Jane Doe

Bond Portfolio Report: Quarter 0

Book Value of Portfolio 180,000.00

Market Value of Portfolio 181,163.61

Maturity (start of) Coupon Rate Market Price Market Yield Bank Holdings

Quarter T+1 1,000.00 22,500.00

Quarter T+2 62.30 1,004.95 4.23 22,500.00

Quarter T+3 62.30 1,006.90 4.83 22,500.00

Quarter T+4 62.30 1,008.82 5.03 22,500.00

Quarter T+5 62.30 1,009.77 5.23 22,500.00

Quarter T+6 62.30 1,009.18 5.48 22,500.00

Quarter T+7 62.30 1,007.46 5.73 22,500.00

Quarter T+8 62.30 1,004.63 5.98 22,500.00

Quarter T+9 62.30 1,000.00 6.23

B.7. Regional Interest Rate ReportGame: Regional-Low Cost Template

Player: Jane Doe

Regional Interest Rate Report: Quarter 0

Fixed Floating Install- Mort- Retail Corp. Pass-

Rate Rate ment gage Demand Demand book Retail

Loans Loans Loans Loans Deposits Deposits Savings CDs IRAs

RegionalLow-Cost

9.30 4.00 11.00 9.00 0.00 0.00 5.00 6.00 7.50


83

B.8. Bond Market ReportGame: Regional-Low Cost Template

Player: Jane Doe

Bond Market Report: Quarter 0

Gross Domestic Product ($ billions) 4,918.73

Floating-rate Loan Base 4.23

Maturity (start of) Coupon Rate Market Price Market Yield

Quarter T+1 1,000.00

Quarter T+2 62.30 1,004.95 4.23

Quarter T+3 62.30 1,006.90 4.83

Quarter T+4 62.30 1,008.82 5.03

Quarter T+5 62.30 1,009.77 5.23

Quarter T+6 62.30 1,009.18 5.48

Quarter T+7 62.30 1,007.46 5.73

Quarter T+8 62.30 1,004.63 5.98

Quarter T+9 62.30 1,000.00 6.23

B.9. Economic Environment ReportGame: Regional-Low Cost Template

Player: Jane Doe

Economic Environment Report: Quarter 0

CAPITAL REQUIREMENTS

Retail Demand Deposits 1,138.60

Corporate Demand Deposits 464.57

Retail Demand Deposits 1,138.60

DEPOSIT RESTRICTIONS

Retail Demand Deposits

Reserve Requirement 10.00

Interest Rate Ceiling 0.00

Corporate Demand Deposits


Interest Rate Ceiling 0.00

Passbook Savings Deposits


Interest Rate Ceiling -9900.00

Retail CDs



Individual Retirement Accounts



84

Game: Regional-Low Cost Template

Player: Jane Doe

Economic Environment Report: Quarter 0


Negotiable CDs


ASSET RISK WEIGHTS

Required Reserves 0

Excess Reserves 20

Federal Funds Sold 20

Fixed Rate Corporate Loans 100

Floating Rate Corporate Loans 100

Installment Loans 100

Mortgages 50

Bonds 0

Fixed Assets 100

OTHER RATES

Annualized FDIC Premium 0.28

Annualized Discount Window Penalty 1.25

LLA Required (%) for Nonperforming Loans 100

Corporate Income Tax Rate 35

Long-term Capital Gains Rate 35

Capital Gains Holding Period 0

Simulation Version 3.0021

B.10. Performance ReportGame: NewWorld Bancorp, Ltd.

Player: Jane Doe

Performance Report: Quarter 0

Number Price Current

Bank Bank Market Times Cumulative per Net

Name Number Market Value Recapitalized Dividends Share Income

Region-al Low-Cost

1 Mkt. A 60,484.86 0 0.00 60.48 1881.26


85

player's manual - college of business · operating cost example #1: ... probanker provides...

Documents