Transcript Money and Banking - Holy Family University

Chapter 9: Bank Management
Chapter Objectives
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Explain what a balance sheet and a T-account are.
Explain what banks do in five words and also at length.
Describe how bankers manage their banks’ balance sheets.
Explain why regulators mandate minimum reserve and capital ratios.
Describe how bankers manage credit risk.
Describe how bankers manage interest rate risk.
Describe off-balance sheet activities and explain their importance.
1. The Balance Sheet
Chapter Objectives
• Explain what a balance sheet and a T-account are.
What is a balance sheet and what are the major types
of bank assets and liabilities?
1. The Balance Sheet
• Liabilities – money that companies borrow in order
to buy assets
• Equity (Net Worth or Capital) – residual that makes
the two sides of the equation balance (banks have
little)
– A company is economically viable if what it owns exceeds the value of
what it owes (Equity is positive)
– A company is not economically viable if the value of what it owes
exceeds the value of what it owns. (Equity is negative)
• The value of assets and liabilities (equity) fluctuates
due to changes in interest rates and asset prices
1. The Balance Sheet
For banks
• Reserves: In this context, cash funds that
bankers maintain to meet deposit outflows
and other payments
• Required reserves: A minimum amount of
cash funds that banks are required by
regulators to hold
• Secondary reserves: Noncash, liquid assets,
like government bonds, that bankers can
quickly sell to obtain cash
Assets
• Commercial banks own
– Reserves of cash and deposits with the Fed
– Secondary reserves of government and other
liquid securities
– Loans to businesses, consumers, and other banks
– Other assets, including buildings, computer
systems, and other physical stuff
Liabilities
• The right-hand side of the balance sheet lists a
bank’s liabilities or the sources of its fund
• Deposits:
– Transaction deposits: negotiable order of
withdrawal accounts and money market deposit
accounts
– Non-transaction deposits: savings, negotiable
certificates of deposit
– Time deposits
Liabilities
Bank Holding Company
• A corporate entity than owns one or more banks
and banking-related subsidiaries
T-Accounts
• Asset transformation and balance sheets provide us
with only a snapshot view of a financial
intermediary’s business
– Intermediaries, like banks, are dynamic places
where changes constantly occur
• The easiest way to analyze this dynamism is
via so-called T-accounts
– Simplified balance sheets that list only changes in
liabilities and assets
3. Bank Management Principles
Chapter Objectives
• Describe how bankers manage their banks’ balance sheets.
• Explain why regulators mandate minimum reserve and capital ratios.
What are the major problems facing bank managers
and why is bank management closely regulated?
Bank management risks
• While earning profits and managing liquidity
and capital, banks face two major risks:
– Credit risk - The risk of borrowers defaulting on
the loans and securities it owns
– Interest rate risk - The risk that interest rate
changes will decrease the returns on its assets
and/or increase the cost of its liabilities
3. Bank Management Principles
Liquidity management
Net deposit outflow (inflow)

Reserve ratio decreases
(increase)
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Increase (decrease) reserves
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in the cheapest way possible
Sell (buy) assets
• high transaction costs
Sell (extend) loans
• adverse selection
Sell (buy) securities
Call in (extend) loans
• high opportunity costs
Increase (decrease) deposits
• high transaction costs and
added operating costs
Borrow from discount window
(Fed)
Borrow from (lend to) Fed
Funds (other banks)
3. Bank Management Principles
Asset management
• Entails the usual trade-off between risk and
return
• Bankers should diversify, make loans to a
variety of different types of borrowers,
– Preferably in different geographic regions
• Bankers need secondary reserves, some assets
that can be quickly and cheaply sold to bolster
reserves if need be
4. Credit Risk
No matter how good bankers are at asset, liability,
and capital adequacy management, they will be
failures if they cannot manage credit risk.
Managing credit risk  managing
• Asymmetric information
• Adverse selection
• Moral hazard
4. Credit Risk
Managing asymmetric information
Screening
reduce adverse selection
Specialization
Increase efficiency
Long-term
reduce moral hazard
create information/reduce asymmetry
embed information in binding contract
third-party verification
maximize efficiency of screening
create exposure to systemic risk
loan commitments (line of credit)
other business services
4. Credit Risk
Managing asymmetric information
Securitize
reduce moral hazard
Credit rationing
reduce adverse selection
reduce moral hazard
collateral
compensatory balances
loan covenants
no credit at any interest rate
limit credit
5. Interest-Rate Risk
• Financial intermediaries are exposed to interest rate
risk because their assets and liabilities are exposed to
interest rate risk.
• Interest rate risk is determined by the value of risksensitive assets, the value of risk-sensitive liabilities,
and the change in interest rates.
6. Off the Balance Sheet
Chapter Objectives
• Describe off-balance sheet activities and explain their importance.
What are off-balance-sheet activities and why do
bankers engage in them?
6. Off the Balance Sheet
• Banks and other financial intermediaries take offbalance-sheet positions in derivatives markets,
including futures and interest rate swaps
– Use derivatives to hedge their risks
• Try to earn income should the bank’s main business suffer a
decline if, say, interest rates rise
– Hedge their interest rate risk by engaging in interest
rate swaps
– Speculate in derivatives and the foreign exchange
markets, hoping to make a big killing
6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
“Credit default swaps, which were invented by Wall Street in the
late 1990's, are financial instruments that are intended to cover
losses to banks and bondholders when a particular bond or
security goes into default -- that is, when the stream of revenue
behind the loan becomes insufficient to meet the payments that
were promised.
Credit default swaps are a type of credit insurance contract in
which one party pays another party to protect it from the risk of
default on a particular debt instrument. If that debt instrument (a
bond, a bank loan, a mortgage) defaults, the insurer compensates
the insured for his loss.”
The New York Times, as quoted in Times Topics
6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
“The market for the credit default swaps has been enormous. Since
2000, it has ballooned from $900 billion to more than $45.5 trillion
— roughly twice the size of the entire United States stock market.
Also in sharp contrast to traditional insurance, the swaps are totally
unregulated.…
The swaps' complexity and the lack of information in an unregulated
market added to the market's anxiety. Bond insurers like MBNA
and Ambac that had written large amounts of the swaps saw their
shares plunge in late 2007..”
Michael Lewitt, September 16, 2008, The New York Times, as quoted in
Times Topics