banking and the management of financial institutions chapter 17 by; sajad ahmad

Banking and the Management of Financial Institutions

Chapter 17Chapter 17By;By;

Sajad AhmadSajad Ahmad

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In this chapter, we examine how banking is conducted to earn the highest profits possible. In the commercial banking setting, we look at loans, balance sheet management, and income determinants.

Topics include:◦The Bank Balance Sheet◦Basics of Banking◦General Principles of Bank Management◦Off-Balance Sheet Activities◦Measuring Bank Performance

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The Bank Balance SheetThe Bank Balance SheetThe Balance Sheet is a list of a bank’s assets and

liabilities

◦ Total assets = total liabilities + capital (total equity)

A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets)

Banks obtain funds by borrowing and by issuing other liabilities such as deposits

They use these funds to acquire assets such as securities and loans

Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers.

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The Bank Balance SheetThe Bank Balance Sheet

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The Bank Balance Sheet: The Bank Balance Sheet: Liabilities Liabilities Checkable Deposits: includes all

accounts that allow the owner (depositor) to write checks to third parties; examples include non-interest earning checking accounts (known as DDAs—demand deposit accounts), interest earning negotiable orders of withdrawal (NOW) accounts, and money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts

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The Bank Balance Sheet: The Bank Balance Sheet: LiabilitiesLiabilities

Checkable deposits are payable on demandCheckable deposits are a bank’s lowest cost

funds because depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes.

The bank’s cost of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts.◦Such as processing, preparing, and sending

out monthly statements, providing tellers...

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The Bank Balance Sheet: The Bank Balance Sheet: Liabilities Liabilities Nontransaction Deposits: are the overall

primary source of bank liabilities and are accounts from which the depositor cannot write checks; examples include savings accounts and time deposits (also known as CDs or certificates of deposit)◦ Savings accounts: In these accounts funds can

be added or from which funds can be withdrawn at any time. Transactions and interest payments are

recorded in a monthly statement◦ Time deposits have a fixed maturity length,

ranging from several months to over five years, and assess penalties for early withdrawal.

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The Bank Balance Sheet: The Bank Balance Sheet: LiabilitiesLiabilitiesNontransaction deposits are generally

a bank’s highest cost funds because banks want deposits which are more stable and predictable and will pay more to the depositors (funds suppliers) in order to achieve such attributes.

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The Bank Balance Sheet: The Bank Balance Sheet: LiabilitiesLiabilities

Borrowings: banks obtain funds by borrowing from the Federal Reserve System, other banks, and corporations; these borrowings are called: discount loans/advances (from the Fed), fed funds (from other banks), interbank offshore dollar deposits (from other banks), repurchase agreements ( “repos” from other banks and companies), commercial paper and notes (from companies and institutional investors)

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The Bank Balance Sheet: The Bank Balance Sheet: Liabilities Liabilities

Bank Capital: is the source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings.

Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write-offs (capital is also called the balance sheet’s “shock absorber,” thus capital levels are important).

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The Bank Balance Sheet: The Bank Balance Sheet: AssetsAssetsReserves: funds held in account with the

Fed and the currency that is physically held by banks (called vault cash as well).

Reserves do not pay any interest. Still banks hold them for two reasons:◦Required reserves are held because of

reserve requirements, is required by law under current required reserve ratios.

◦ Any reserves beyond this area called excess reserves. They are the most liquid assets and used to meet its obligations.

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The Bank Balance Sheet: The Bank Balance Sheet: AssetsAssets

Cash items in Process of Collection: checks deposited at a bank, but where the funds have not yet been transferred from the other bank.◦ It is an assets for your bank because it is a

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

Deposits at Other Banks: usually deposits from small banks at larger banks

Reserves, Cash items in Process of Collection, and Deposits at Other Banks are collectively referred to as Cash Items generally in the balance sheet.

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The Bank Balance Sheet: The Bank Balance Sheet: AssetsAssetsSecurities: these are either U.S.

government/agency debt, municipal debt, and other (non-equity) securities.◦ Short-term Treasury debt is often referred

to as secondary reserves because of its high liquidity.

Loans: are a bank’s income-earning assets, such as business loans, auto loans, and mortgages. ◦These are generally not very liquid. ◦Loans also have a higher probability of

default than other assets. Banks earns its highest return on loans. 17-13

The Bank Balance Sheet: The Bank Balance Sheet: AssetsAssetsMost banks tend to specialize in either

consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry).

Other Assets: the physical capital such as bank buildings, computer systems, and other equipment owned by the banks is included in this category.

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Basics of BankingBasics of Banking

Before we explore the main role of banks—that is, asset transformation—it is helpful to understand some of the simple accounting associated with the process of banking. But think beyond the debits/credit – and try to see that banks engage in asset transformation.

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Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan. Banks tend to “borrow short and lend long” (in terms of maturity).

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T-account Analysis:

◦Deposit of $100 cash into First National Bank

First National BankAssets Liabilities

Vault cash +$100 Checkabledeposits

+$100

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First National BankAssets Liabilities

Cash items inprocess ofcollection

+$100 Checkabledeposits

+$100


Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount

First National Bank Assets Liabilities

Reserves +$100 Deposits +$100

Deposit of $100 check

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This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded.

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T-account Analysis:



Required reserves Excess reserves

+$10 +$90

Checkable deposits

+$100

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As we can see, $10 of the deposit must remain with the bank to meeting federal regulations. Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers.

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T-account Analysis:



Required reserves Loans

+$10 +$90

Checkable deposits

+$100

General PrinciplesGeneral Principles of Bank of Bank ManagementManagement The bank has four primary concerns:1. Liquidity management

◦ The acquisition of sufficiently liquid assets to meet the bank’s obligation to depositors.

2. Asset management◦ The bank manager must try to keep level

of risk low by acquiring assets that have a low rate of default and diversifying asset holdings-managing credit risk

◦ Also try to match the maturity of assets and liabilities-managing interest-rate risk

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General PrinciplesGeneral Principles of Bank of Bank ManagementManagement

3. Liability management◦ The bank manager must try to acquire

funds at low cost.4. Managing capital adequacy

◦ The bank manager must decide the amount of capital the bank should maintain and then acquire the needed capital.

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Liquidity Management and the Role Liquidity Management and the Role of Reservesof Reserves

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Liquidity ManagementReserves requirement = 10%, Excess reserves = $10 million

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million


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

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Deposit outflow of $10 millionAssets Liabilities





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

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No excess reservesAssets Liabilities




Deposit outflow of $10 millionAssets Liabilities





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1. Borrow from other banks or corporationsAssets Liabilities


Loans $90 million Borrowings $9 million

Securities $10 million Bank Capital $10 million

2. Sell securitiesAssets Liabilities





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3. Borrow from Fed Assets Liabilities


Loans $90 million Discount Loans $9 million

Securities $10 million Bank Capital $10 million

4. Call in or sell off loansAssets Liabilities




Liquidity Management and the Role Liquidity Management and the Role of Reservesof ReservesThus bank hold excess reserves instead of

investing the funds into securities or extending loans with higher returns in order to escape the costs of◦Borrowing from other banks or corporations◦Selling securities◦Borrowing from the Fed◦Calling in or selling off loans

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

The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold.

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Asset ManagementAsset ManagementAsset Management: the attempt to earn the

highest possible return on assets while minimizing the risk.

Banks try to manage their assets by four basic way:

1. Try to find borrowers who will pay high interest rates and unlikely to default on their loans.

2. Try to buy securities with high return, low risk.

3. Try to lower risk by diversifying.

4. Try to manage liquidity to satisfy its reserve requirements without bearing huge costs.

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Liability ManagementLiability Management

Liability Management: managing the source of funds, from deposits, to CDs, to other debt.

1. Important since 1960s

2. No longer primarily depend on deposits

3. When see loan opportunities, borrow or issue CDs to acquire funds

It’s important to understand that banks now manage both sides of the balance sheet together, whereas it was more separate in the past. Indeed, most banks now manage this via the asset-liability management (ALM) committee.

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Capital Adequacy ManagementCapital Adequacy Management

Banks have to control their capital for three reasons:

◦ Bank capital helps prevent bank failure Bank failure is a situation in which the

bank cannot satisfy its obligations to pay its depositors and other creditors and so goes out of business.

◦ The amount of capital affects returns for the owner (equity holders) of the bank.

◦ A minimum amount of bank capital (bank capital requirement) is required by regulatory authorities

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1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:

Low Capital Bank Assets Liabilities



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High Capital Bank Assets Liabilities



Capital Adequacy Capital Adequacy ManagementManagement

Impact of $5 million loan loss

Low Capital Bank Assets Liabilities


Loans $85 million Bank Capital -$1 million

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High Capital Bank Assets Liabilities



Conclusion: A bank maintains reserves to lessen the chance that it will become insolvent.

Capital Adequacy ManagementCapital Adequacy Management Higher is bank capital, lower is return on

equity

◦ ROA = Net Profits/Assets

Provides information on how efficiently a bank is being run

It indicates how much profits are generated on average by each dollar of assets

◦ ROE = Net Profits/Equity Capital

Shows how much the bank is earning on their equity investment.

Net profit after taxes per dollar of equity (bank) capital

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◦ EM = Assets/Equity Capital

Amount of assets per dollar of equity capital

◦ ROE = ROA EM

◦ Capital , EM , ROE

◦ Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

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Tradeoff between safety (high capital) and ROE

◦ Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy.

◦ Bank capital is also costly because the higher it is, the lower will be the return on equity for a given return on assets.

Banks also hold capital to meet capital requirements asked by the regulatory authorities.

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The Practicing Manager: The Practicing Manager:

Strategies for Managing Capital: what should a bank manager do if she feels the bank is holding too much capital?

• Sell or retire stock

• Increase dividends to reduce retained earnings

• Increase asset growth via debt (like CDs)

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The Practicing Manager: The Practicing Manager:

Reversing these strategies will help a manager if she feels the bank is holding too little capital?

• Issue stock

• Decrease dividends to increase retained earnings

• Slow asset growth (retire debt)

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The Capital Crunch and the The Capital Crunch and the Credit Crunch in the early 1990sCredit Crunch in the early 1990s

Did the capital crunch cause the credit crunch in the early 1990s?◦In 1990 and 1991 credit growth slowed

to an extremely low pace◦Our analysis suggests that a capital

crunch was a likely cause. Loan losses in the late 80s and an increase in capital requirements immediately preceded this period.

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The Capital Crunch and the The Capital Crunch and the Credit Crunch in the early 1990sCredit Crunch in the early 1990s

Did the capital crunch cause the credit crunch in the early 1990s?◦Banks were forced to either (1) raise

new capital or (2) reduce lending. Guess which route they chose?

Off-Balance-Sheet ActivitiesOff-Balance-Sheet Activities

Involve trading financial instruments and generating income from fees and loan sales.

Activities that affect bank profits but do not appear on bank balance sheets.

The activities:1.Loan sales (secondary loan participation):

involves a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan from the bank’s balance sheet.◦ Banks earn profits by selling loans for an

amount slightly greater than the amount of the original loan.

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Off-Balance-Sheet ActivitiesOff-Balance-Sheet Activities◦ The high interest rate on these loans

makes them attractive so institutions are willing to buy them even though they pay high price.

2. Generation of Fee income◦ Foreign exchange trades for customers◦ Servicing mortgage-backed securities◦ Guarantees of debt (banker’s

acceptances)◦ Backup lines of credit

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Measuring Bank PerformanceMeasuring Bank PerformanceMuch like any business, measuring bank

performance requires a look at the income statement. For banks, this is separated into three parts:◦Operating Income

Is the income that comes from a bank’s ongoing operations.

It is composed of interest income and non-interest income

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Measuring Bank PerformanceMeasuring Bank Performance

◦Operating Expenses Are the expenses incurred in conducting

the bank’s ongoing operations. Again composed of interest and non-

interest expenses

◦Net Operating Income Difference between income and

expenses Indicates how well the bank is doing on

an ongoing basis.

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Banks' Income Banks' Income StatementStatement

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Measuring Bank PerformanceMeasuring Bank Performance

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks.

The most commonly used ratios are ROA and ROE.

Besides NIM (net interest margin) is also looked at.◦NIM = [Interest Income - Interest Expenses]/

Assets◦ It is the difference between interest income

and interest expense as a percentage of total assets.

◦ It shows how well a bank manages its assets and liabilities.

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banking and the management of financial institutions chapter 17 by; sajad ahmad

Documents

accounts funds

liabilities checkable

banks assets

assets banks

balance sheet management

banks cost

loans banks

bank performance