Banking and the Management of Financial Institution

The bank borrows short and lends long -> how banks generate profits

General Principles of Bank Management

Liquidity Management and the Role of Reserves

The management of liquid assets to meet banks obligations to depositors

The banks need % of total deposits as reserves for the withdrawal of such

Shortage:

Borrowing: the cost is the interest rate

Sell securities: the cost is the transaction costs

Borrow from Fed (discount loans): the cost is the interest rate (discount rate)

Asset Management

The bank must pursue an acceptably low level of risk by acquiring assets that have low rate of default and by diversifying asset holdings

1) Find borrowers who will pay high interest rates

2) Purchase securities with high returns and low risk

3) Lower risk (of 2) by diversifying

4) Balance need for liquidity (hold liquid assets even though they have low returns)

Liability Management

Acquire funds in low cost

Capital Adequacy Management

Bank Failure:: Bank A: 10M Capital; Bank B: 4M Capital

If the bank realizes that 5 million of the loans lent out will not be recoverable, Bank A will still have 5M in the capital while Bank B will have a problem since it has -1M

apital

Affects Returns to Equity Holders

Managing Interest-Rate Risk

If a bank has more rate-sensitive liabilities than assets:

Increase in interest rates -> will reduce bank profits

Decrease in interest rates -> will increase bank profits

Gap and Duration Analysis

Off-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 the balance sheet