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Bank Management
General Principles
Primary Concerns of the Bank
Manager
• Deposit outflows must match deposit
inflows.
– To keep enough cash on hand, the bank
manager must engage in liquidity management.
• Risk levels must be acceptably low.
– To keep risk low, the bank manager must
engage in asset management by acquiring
assets that have a low rate of default and by
holding a portfolio that is well diversified.
Primary Concerns of the Bank
Manager
• Funds must be acquired at low cost.
– To increase profits by acquiring funds at low
cost, the bank manager engages in liability
management.
• Capital must meet regulatory standards.
– To maintain and acquire capital, the bank
manager engages in capital adequacy
management.
Liquidity Management
• Financial institutions face liquidity
management problems because the volume
of cash flowing in rarely matches exactly
the volume of cash flowing out.
• In addition, some liabilities are payable
immediately upon demand, resulting in the
outflow of cash with little or no notice.
And...
Liquidity Management
• Financial institutions are sensitive to
interest rate movements, which affect the
flow of savings they attract from the public
and the earnings from the loans and
securities they acquire.
Liquidity Management
• Liquidity managers usually meet their
institutions’ cash needs through two
methods:
– Asset management or conversion; ie., the
selling of selected assets.
– Liability management; ie., the borrowing of
enough liquidity to cover a financial
institution’s cash demands as they arise.
Sources and Uses of Funds
Method
• To estimate the financial institution’s future
liquidity needs, the bank manager could use
the sources and uses of funds method.
– The institution’s estimated liquidity deficit or
surplus equals the estimated change in liquidity
sources minus the estimated change in liquidity
uses.
Sources and Uses of Funds
Method: Example
Planning
Interval
Tomorrow
Next Day
Estimated Change in
Funds Sources
+$25 million
-$10 million
Estimated Change in
in Funds Uses
+$20 million
+$10 million
Estimated
Surplus/ Deficit
+$5 million
-$20 million
The bank manager could invest the $5 million surplus
overnight in order to earn interest income, and then the
next day must borrow $20 million from some other institution.
The Structure of Funds Method
• To estimate the financial institution’s future
liquidity needs, the bank manager could use
the structure of funds method.
– The institution’s liabilities are divided into
categories based on their estimated probability
of leaving the institution. Funds are then
allocated to cover those liabilities according to
the likelihood that they will leave.
The Structure of Funds Method:
Example
• Some funds received may be “hot money”
that are highly sensitive to changes in
interest rates.
– 90% or more of these funds should be covered
with holdings of liquid assets or borrowings.
• Other funds are “core” funds that are highly
stable.
– Only 10% of these funds might be covered
10%.
The Structure of Funds Method:
Example
Estimated liquidity need = 0.90 x (“Hot money” funds) + 0.10 x (“Core” funds)
+ Estimated new loan demand from customers
= 0.90 x ($60 million) + 0.10 x ($100 million)
+ $36 million = $100 million
The liquidity manager would want to make sure that $100
million was available in some combination of holdings of
liquid assets and borrowing capability.
Liquidity Indicators
• Liquidity indicators supply bank managers
with signs that a liquidity problem is
developing. They include:
– Ratio of cash to total assets.
– Ratio of “hot money” assets to “hot money”
liabilities.
– Cost of borrowing for liquidity needs relative to
the cost other institutions face.
– Monitoring the intentions of the bank’s biggest
customers.
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$20
$80
$10
Liabilities
Deposits
Bank Capital
$100
$ 10
Let the bank’s reserve requirement be 10% of deposits or $10.
Under these circumstances, an unexpected deposit outflow of
$10 presents no problems for the bank. Why?
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$10
$80
$10
Liabilities
Deposits
Bank Capital
$ 90
$ 10
The bank loses $10 of deposits and $10 of reserves, but since
required reserves are now 10% of $90, it still has $1 in excess reserves.
If a bank has ample reserves, a deposit outflow does not necessitate
changes in other parts of its balance sheet.
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$10
$90
$10
Liabilities
Deposits
Bank Capital
$100
$ 10
Let the bank’s reserve requirement be 10% of deposits or $10.
Under these circumstances, an unexpected deposit outflow of
$10 does present a problem for the bank. Why?
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$ 0
$90
$10
Liabilities
Deposits
Bank Capital
$ 90
$ 10
After the withdrawal of $10 in deposits, the bank needs $9 in
reserves, but it has none.
To eliminate the shortfall, the bank could sell assets or borrow
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$ 9
$90
$10
Liabilities
Deposits
Borrowings
Bank Capital
$ 90
$ 9
$ 10
If the bank borrows $9 from other banks or corporations, the bank
incurs the cost associated with the borrowing.
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$ 9
$90
$ 1
Liabilities
Deposits
$ 90
Bank Capital
$ 10
If the bank sells securities, the bank incurs the costs associated
with the sale. These costs include brokerage and other transactions
costs as well as the loss of future income.
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$ 9
$90
$10
Liabilities
Deposits
Discount Loan
Bank Capital
$ 90
$ 9
$ 10
If the bank borrows from the Federal Reserve, it also incurs costs.
The bank must pay the discount rate charged on Fed loans, and
the bank risks losing its privilege of borrowing from the Fed, if it
borrows too often.
Liquidity Management and the
Role of Reserves
Assets
Reserves
Loans
Securities
$ 9
$81
$10
Liabilities
Deposits
$ 90
Bank Capital
$ 10
If the bank calls or sells some loans, the bank incurs the costs
associated with the reduction of loans. This is the costliest way
of acquiring reserves.
Liquidity Management:
Conclusion
• 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.
Bank Management II
General Principles
Asset Management
• To maximize profits, a bank must
simultaneously seek the highest returns
possible on loans and securities, reduce risk,
and make adequate provisions for liquidity
by holding liquid assets.
Asset Management
• Four basic methods of asset management:
– Find borrowers who will pay high interest rates
and are unlikely to default.
– Purchase securities with high returns and low
risk.
– Lower risk by diversifying.
– Manage the liquidity of its assets so that it can
satisfy its reserve requirements without
incurring large costs.
Liability Management
• Today, banks regularly engage in liability
management.
– When a bank finds an attractive loan
opportunity, it can acquire funds by selling
negotiable CDs.
– If it has a reserve shortfall, it can borrow from
other banks in the federal funds markets.
Raising Funds for a Financial
Institution
• Factors to be considered:
– The relative cost of raising funds from each
source.
– The risk (volatility or dependability) of each
fund’s source.
– The length of time (maturity) for which a
source of funds will be needed.
– The size and market access of the financial
institution attempting to raise funds.
– Laws and regulations that limit access to funds.
Relative Cost Factor
• The relative cost factor is important
because, other things remaining the same, a
financial institution would prefer to borrow
from the cheapest sources of funds
available.
• Also, if an institution is to maintain
consistent profitability, its cost of fund
raising must be kept below the returns
earned on the sales of its services.
Pooled-Funds Approach:
Example
Sources of New Funds
Volume of New
Funds Generated
Interest Costs & Other
Expenses Incurred
Deposits
Money Market Borrowing
Equity Capital
$200
$ 50
$ 50
$20
$ 5
$ 5
Total New Funds
$300
$30
Estimated overall cost of funds for the institution is:
Pooled
Fund Raising
Expense
=
All Expected
Fund Raising Costs
Total New Funds
=
$30 =
$300
10%
Pooled-Funds Approach:
Example
If only $250 of the $300 in funds raised can be used to invest in new loans and
investments, the estimated overall cost of funds changes.
Estimated overall cost of funds for the institution is:
Pooled
Fund Raising
Expense
=
All Expected
Fund Raising Costs
Total New Funds
=
$30 =
$250
12%
Now the bank must earn at least 12% on its loans and other earning assets just to
cover its fund-raising costs. When it could use all the funds raised for loans and
other investments, it only needed to earn 10% to cover the fund-raising costs.
Capital Adequacy
• Functions of bank capital:
– Help to prevent bank failure
– Affects returns for equity holders
– Required by regulatory authorities
Capital and Bank Failure
High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
Reserves $10
Loans
$90
Reserves $10 Deposits
Loans $90 Bank K
Deposits $90
Bank K
$10
$96
$ 4
Assume that both banks write off $5 of their loan portfolio. Total
assets decline by $5, and bank capital, which equals assets minus
liabilities, also declines by $5.
Capital and Bank Failure
High Capital Bank
Assets
Liabilities
Low Capital Bank
Assets
Liabilities
Reserves $10
Loans
$85
Reserves $10 Deposits $96
Loans $85 Bank K - $ 1
Deposits $90
Bank K
$ 5
After the write-off, the high capital bank still has a positive net
worth, but the low capital bank is insolvent. It does not have
sufficient assets to pay off its creditors. Regulators will now close
the bank and sell its assets.
A bank maintains bank capital to lessen the chance that it will
become insolvent.
Bank Capital and Returns to
Owners
A basic measure of bank profitability is return on assets = ROA
ROA = Net profit after taxes/assets.
This measure provides information on how efficiently a bank is
being run because it indicates how much profit is generated on
average by each dollar of assets.
Bank Capital and Returns to
Owners
Another measure of bank profitability is return on equity = ROE
ROE = Net profit after taxes/Equity capital.
This measure provides information on how much the bank is
earning on the investors’ equity investment.
Bank Capital and Returns to
Owners
There is a direct relationship between the return on assets and the
return on equity. This relationship is determined by the equitymultiplier (EM). EM is the amount of assets per dollar of
equity capital.
EM = Assets/equity capital
Net profit after taxes Net profit after taxes x
Assets
=
Equity capital
Assets
equity capital
ROE
=
ROA x EM
Bank Capital and Returns to
Owners
We can use the ROE formula to examine what happens to the return
on equity when a bank holds a smaller amount of assets per dollar
of capital. Let each bank receive a return on assets equal 1%.
ROE
=
ROA x EM
High Capital Bank ROE
=
1% x 100/10
Low Capital Bank ROE
=
1% x 100/4
=
=
10%
25%
Given the return on assets, the lower the bank capital, the higher the
return for the owners of the bank.
Trade-off between Safety and
Return
• Bank capital reduces the likelihood of
bankruptcy, but it is costly because as bank
capital rises, return on equity falls.
• Bank managers must determine how much
safety they are willing to trade off against
the lower return on equity.
• The more uncertain the times, the larger the
amount of capital held.
Bank Capital and Returns to
Owners
Another commonly watched measure of bank performance is called
the net interest margin (NIM), the difference between interest income
and interest expenses as a percentage of total assets.
NIM = interest income - interest expenses
assets
If a bank manager has done a good job, the bank will have high
profits and low costs. This is reflected in the spread between interest
earned and interest costs.
Bank Capital Requirements
• Basle Agreement
– An agreement among the central banks of
leading industrialized nations, including the
nations of Western Europe, the United States,
and Japan, to impose common capital
requirements on all their banks in order to
control bank risk exposure and avoid giving
one nation’s banks an unfair advantage over
another nation’s banks. It provides minimum
capital standards.
Basle Agreement
• The Basle Agreement (1998) stipulates that banks
in all participating nations must have a minimum
ratio of total capital to risk-weighted assets and
other related risk-exposed items of 8 percent.
• Risk weighted assets are determined by classifying
each of the bank’s assets listed on its balance sheet
into categories based on risk exposure and then
multiplying each category by a fractional risk
weight ranging from 0 for cash and government
securities to 1 for commercial loans and other high
risk assets.
Basle Agreement: Example
0 x (Cash and U.S. government securities) + 0.2 x
(Other types of government securities and interbank
Total risk-weighted assets = deposits) + 0.5 x (Residential mortgage loans,
on a bank’s balance sheet
government revenue bonds and selected types of
mortgage backed securities) + 1 x (Commercial
and consumer loans and other assets of the highest
risk exposure).
Basle Agreement
• The Basle Agreement was unique in also including
off-balance sheet commitments that banks make to
their largest customers, as well as commitments
banks make to hedge themselves against risk.
• The amount of each off-balance sheet item is
multiplied by a fractional amount know as its
“credit-equivalent” value, which is, in turn,
multiplied by a fractional risk weight based on its
assumed degree of risk exposure.
Basle Agreement: Example
Total risk-weighted assets
on and off a bank’s balance =
sheet
Total risk-weighted
assets on a bank’s
balance sheet
Total risk-weighted
x
off-balance sheet items
Basle Agreement
• To determine a bank’s total capital, its longermaturity liabilities and its equity are classified into
two broad categories:
– Tier-one or permanent core bank capital which
includes:
• Tangible equity including common stock + perpetual preferred
stock + retained earnings + capital reserves less intangibles.
– Tier-two or supplemental capital which includes:
• Subordinated capital notes and debentures over 5 years to
maturity +limited-life preferred stock + loan loss reserves.
Basle Agreement
• The Basle Agreement requires each bank in all
participating countries to achieve and hold the
following capital minimums:
– Tier-one capital divided by total risk-weighted on and
off balance sheet items must equal at least 4%.
– Total tier-one plus tier two capital divided by total riskweighted on and off balance sheet items must equal no
less than 8%.
• A bank with a 4% tier-one capital ratio and a 5% tier-two
capital ratio would have a ratio of total capital to risk-weighted
on and off balance sheet items of 9%.
Basle Agreement
• In the U.S. and selected other countries, a
bank that holds more than the required
minimum amounts of capital is allowed to
expand its services and service facilities
with few or no regulatory restrictions
imposed.
• But, if bank capital drops below the
minimum percentage, regulatory restrictions
become increasingly stiff.
Off Balance-Sheet Activities
• Loan sales or secondary loan participation
– 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.
– Institutions are willing to buy them at the high price
because of the high interest rates associated with the loans.
Off Balance-Sheet Activities
• Generation of Fee Income
– Banks charge fees for specialized services such
as:
• Making foreign exchange trades
• Servicing a mortgage-backed security by collecting
interest and principal payments and then paying
them out, and providing lines of credit.