BANK MANAGEMENT BANK PERFORMANCE
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Transcript BANK MANAGEMENT BANK PERFORMANCE
CHAPTERS 19, 20
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Bank Profits
P = Loans x Realized Loan Yield - Deposits x Cost per $ of
Deposits - Fixed Expenses
RLY = Contractual rate x Good Loan Fraction - (1-Recov. rate) x
Bad Loan Fraction
Cost of Deposits = Interest paid plus the cost of free services
Fixed Costs = the cost of everything else the bank needs to run
the business
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B. Realized Loan Yield Example
RLY = Contractual rate x Good Loan Fraction - (1-Recov.
rate) x Bad Loan Fraction
Consider an average rate of 12%, 90% good loans and a
recovery rate of 85% on bad loans. The RLY in this example
is 9.3%
RLY = .12 x .9 - (1-.85) x .10 = .093 or 9.3%
If the bank has a $100,000,000 portfolio, that equates to
$9,300,000 in interest income after writing off $1,500,000
in bad loan losses (against $10,800,000 interest income)
C.
D.
Return on Equity: ROE = Profits / Equity
Methods of Increasing ROE
Lower Equity (increase leverage); a risky move in a volatile
environment – especially during periods of low profitability
Equity Ratio = equity / loans and investments
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3.Raise Profits by increasing revenue:
Increase contractual rates
Lend more money; need to increase deposits,
Decrease free services or start charging for them
Lower variable costs
Lower fixed costs; problem of indivisibility
Tighten loan standards; could result in lowering total loan portfolio
Offer other low-cost high margin services; i.e., brokerage, insurance,
etc
Increasing size to get benefits of scale
Securitizing collateralized loans; retaining servicing fee income
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E.
Market Considerations
Competition limits ability to raise loan rates, reduce services, or
reduce deposit rates
Increasing loan rates and decreasing deposit rates increases the Net
Interest Margin
Ability to make loans a function of;
(1) excess reserves or (2) required reserve ratio
Customers know more than the bank
Problem of asymmetric information
Adverse selection; raise rates and best quality customers may leave
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F.
The Risk-Return Tradeoff
Competition and adverse selection limit ability to increase earnings
from lending
Other investments offer higher returns but carry interest rate risk;
Rather than lending, could invest depositors cash in interest earning
securities
As interest rates change, value of the investment portfolio changes
What happens when value of the assets are less that value of liabilities?
G.
A Final Pass on Deposits, Reserves, and Liquidity
Increasing deposits also increases variable costs
Ability to make loans a function of excess reserves (cash in vault:
opportunity cost)
Liquidity is necessary to service client demand for cash
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Banking Regulation Seeks to Reduce Financial
Shocks
Banks must have higher levels of capital; BIS (Bank for
International Settlements)
Tier 1: Book Value of Stock plus retained earnings
Tier 2: Sum of Loan-Loss reserves and subordinated debt
Total capital = Tier 1 plus Tier 2
How much a bank must have in each category a function
of risk-adjusted assets
Risk-Weighted Capital Requirements and Asset Types;
Cash and Government Securities = 0 risk weight
Loans = 1.0 risk weight
Mortgages = 0.5 weight
Inter bank deposits = 0.2 weight
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3.The [Separate] Leverage Requirement
Tier 1 capital; 3% of all unweighted assets
If risky, may require 4-6%
4.Off-Balance Sheet assets not counted
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B.
Bank Response to New Capital Requirements
Issuance of new stock
Merger with a stronger bank
Shrinking the Balance Sheet.; reduction in assets, w/o
changes in equity, increases equity ratio or pushing for
acquisition by larger bank
Risk weights increase attractiveness of Government
securities. (also subjects them to interest rate risk)
Shifting from riskier assets within each category
Take on more interest- and exchange-rate risk
Take on risk as Forward Intermediary; i.e., selling
derivatives
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The Most Frequently Given Reasons for Bank
Failure
Bank officer fraud
Excessive Bad Loans
Inadequate Liquidity / Inadequate Capital
Deregulation leading to Increase in Competition
Regulatory forbearance
Non preparedness for increase in interest rate risk
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Examining the Proportion of Rate Sensitive Assets and
Liabilities
GAP Analysis → Changes in Income
GAP = Rate Sensitive Assets (RSA) – Rate Sensitive Liabilities (RSL)
DI = GAP * Di
2. Rate Sensitive Assets:
Short-Term Loans (Maturities 1 year or less); commercial or consumer
Variable Rate Mortgages
The proportion of fixed rate mortgages that are repaid early
The proportion of auto loans paid early
3. Rate Sensitive Liabilities
Money Market Deposits
Variable Rate CDs and CDs maturing in 1 year or less
Borrowings with maturities 1 year or less
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B.
Interest Rate Changes and GAP
If a financial institution has more rate sensitive liabilities (RSL)
than rate sensitive assets (RSA), then the GAP will be negative:
GAP = RSA – RSL
If RSL > RSA, then GAP < 0 (negative)
Any increases in Interest rates will reduce the GAP (or net
interest rate margin) and result in net income decline:
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C.
Bank Profits a function of interest rate
expectations
If interest rates expected to go up, then allocate assets to
short-term loans → rollover at higher rates
If interest rates expected to go down, allocate assets to
long-term loans → less rollover
D.
Forecasting interest rates is important
Effects on GAP of Proportions of RSA and RSA
Magnitude of excess reserves is key to loss containment
strategy
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E.
Types of SWAPS:
Fixed rate for Floating Rate Swap: rates calculated at time of swap
Forward Swap; setting the rates now for future swap
Swaptions: hybrid arrangements for early termination
Callable Swap: party making fixed payments option to terminate before
maturity [Desirable if interest rates decline]
Putable Swap: party making floating payments option to terminate before
maturity [Desirable if interest rates increase]
F.
Basis Risk in Swap Transactions
Recall that gains and losses for parties to a futures-type arrangement
stem from
Changes in basis
If fixed rates go up more slowly than variable rates, basis decreases
resulting in increases to the buyer (institution exchanging or paying
fixed rate for variable.)
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Forecasting interest rates is important
Proportions of RSA and RSL - GAP
Magnitude of excess reserves is key to loss containment strategy
Fixed Yields on Loan Portfolios, Variable Costs of Liabilities
Assets and Liabilities tend to be rate sensitive
Allocation of bank resources (assets) a function of interest rate
expectations
If interest rates expected to go up, allocate assets to short-term loans
Rollover at higher rates
If interest rates expected to go down, allocate assets to long-term loans
Less rollover
Cost of liabilities (deposits) tends to be very rate sensitive
The Gap between the Yields on Assets and the Implicit Costs of
Liabilities sensitive to changes in asset maturity and deposit turnover
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Potential Strategies
C.
Maturity matching; would drive Commercial banks to short-term loans
Floating-rate loans; unpopular with borrowers
Financial Futures; high leverage, high risk (basis risk)
Interest Rate Swaps; potentially risky if wrong on expectations or
arrangements
The Interest Rate Swap:
Dealing with changes induced in Interest Revenues and Interest Expense
resulting from changes in market rates
D.
The Scenarios for Interest rate Swaps
Long-Run increase in interest rates; decreases the gap
Long-Run decrease in interest rates; increases the gap
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How are depository institutions' profits determined?
How does the bank realized loan yield (RLY) affected by credit
policies?
If a bank has low ROE (or ROA), what strategies might it pursue?
What determines the ability of a bank to expand loan activity?
What is meant by Adverse Selection? How does it affect bank
operations?
How have banks responded to the capital requirements under the BIS
standard?
What is the single largest source of risk for banks?
What are Swaps and how do banks use them?
What are the ways banks can increase their profits?
What are the two biggest dangers they face in doing so?
Why are banks trying to get larger and to expand their activities?
Q&A 19: 3, 4, 7, 8, 10, Q&A 20: 1, 4, 8, 9
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