Banking and the Management of Financial Institutions The Economics of Money, Banking, and Financial Markets Mishkin, 7th ed. Chapter 9 Banking and the Management of Financial Institutions

Balance Sheet Total assets = total liabilities + capital Assets = uses of funds Liabilities = sources of funds Financial institution issue liabilities (deposit accounts, CDs, etc) and buy assets (such as loans and government securities)

The Bank Balance Sheet The Bank Balance Sheet

Liabilities Checkable deposits Nontransaction deposits (savings accounts and CDs) Borrowings discount loans, federal funds market from bank holding companies Federal Home Loan Bank Corporations (repurchase agreements) Borrowings provided 2% of bank funds in 1960, but 28% in 2003.

Liabilities (cont.) Bank capital = total assets – total liabilities = bank’s net worth

Assets Cash items Securities – 25% of assets and 10% of revenue Reserves = deposits at Fed + vault cash required and excess reserves Cash items in process of collection Deposits at other banks: correspondent banking Securities – 25% of assets and 10% of revenue U.S. government and agency securities - secondary reserves State and local gov’t and other securities Loans: illiquidity, default risk, => highest returns among assets Other assets (physical capital)

Bank Operation (asset transformation) Conclusion: When bank receives deposits, reserves  by equal amount; when bank loses deposits, reserves  by equal amount. T-account Analysis: (Borrows short & lends long) Case 1: Deposit of $100 cash into First National Bank Assets Liabilities Vault Cash + $100 Checkable Deposits + $100 (=Reserves) Case 2: Deposit of $100 check into First National Bank Cash items in process Checkable Deposits + $100 of collection + $100 Case 2.1: $100 check deposited in 1st National Bank written against an account in 2nd National Bank (after check clears) First National Bank Second National Bank Assets Liabilities Assets Liabilities Checkable Checkable Reserves Deposits Reserves Deposits + $100 + $100 – $100 – $100

Deposits and Reserves When a bank receives new deposits, its reserves increase by the same amount. Under a system of fractional reserve banking, only a fraction of these reserves need be held. Excess reserves may be loaned by banks.

Required and Excess Reserves Bank A receives deposits of $1,000 when the reserve requirement is 20%. Bank A Assets Liabilities Required reserves +200 Checkable deposits +1000 Excess reserves +800

Excess Reserves and Loan (loan is created, but not yet spent) Bank A creates a loan equal to its excess reserves Bank A Assets Liabilities Required reserves +200 Checkable deposits +1800 Excess reserves +800 Loans +800

Excess Reserves and Loan (loan check is cashed) Loan check is cashed and funds are withdrawn from Bank A. Bank A has converted $800 in excess reserves into $800 of loans (converting a non-interest bearing asset into an interest bearing asset. Bank A Assets Liabilities Required reserves +200 Checkable deposits +1000 Loans +800

Principles of Bank Management Liquidity management – ensuring that are sufficient liquid assets to cover deposit outflows Asset management – maintaining low risk and high returns Managing Credit Risk Managing Interest-rate Risk Liability management – obtaining funds at low cost Capital adequacy management – maintaining appropriate level of bank capital

Principles of Bank Management Case 1: enough excess reserves Reserve requirement = 10%, Excess reserves = $10 million Assets Liabilities Reserves $20 million Deposits $100 million Loans $80 million Bank Capital $ 10 million Securities $10 million Deposit outflow of $10 million Reserves $10 million Deposits $ 90 million With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet

Liquidity Management Case 2: No excess reserves Assets Liabilities Reserves $10 million Deposits $100 million Loans $90 million Bank Capital $ 10 million Securities $10 million Deposit outflow of $ 10 million Reserves $ 0 million Deposits $ 90 million

Liquidity Management Case 2.1: Borrow from other banks or corporations Assets Liabilities Reserves $ 9 million Deposits $ 90 million Loans $90 million Borrowings $ 9 million Securities $10 million Bank Capital $ 10 million Case 2.2: Sell Securities Loans $90 million Bank Capital $ 10 million Securities $ 1 million

Liquidity Management Case 2.3: Borrow from Fed Assets Liabilities Reserves $ 9 million Deposits $ 90 million Loans $90 million Discount Loans $ 9 million Securities $10 million Bank Capital $ 10 million Case 2.4: Call in or sell off loans Loans $81 million Bank Capital $ 10 million Securities $10 million Conclusion: excess reserves are insurance against above 4 costs from deposit outflows

Liquidity Management Banks may hold excess reserves to guard against deposit outflows and reserve shortfalls A reserve shortfall may be met costly by: borrowing reserves from other banks in the federal funds market or from corporations (repurchase agreements or negotiable CDs) selling securities (federal securities serve as “secondary reserves”) borrowing from the Fed (discount loans) calling in or sell off loans Banks hold more excess reserves when the cost of a reserve shortfall is higher.

Asset Management To max profit, banks seek the highest returns, lowest risk and more liquidity in 4 ways Try to find borrowers with low default risk who are willing to pay high interest rates. Purchase securities with high return and low risk. Diversify on both securities and loans: “don’t put too many eggs in one basket” Maintain sufficient liquidity so as to satisfy reserve requirements at low cost.

Liability Management Beginning important since 1960s, large banks began experimenting with liabilities that could provide reserves and liquidity: overnight loans, federal funds market, and negotiable CDs. Shift from seeing deposits as a constraint on loans to attempting to acquiring liabilities as needed to fund profitable loan opportunities. When see loan opportunities, borrow or issue CDs to acquire funds: e.g., Negotiable CDs and bank borrowing in 1960 were 2% of liabilities, but were 42% in 2002. Checkable deposits were 61% of liabilities in 1960, but were 9% in 2002.

Capital Adequacy Management Banks must manage bank capital to: help prevent bank failure, help determine the rate of return to owners, and meet regulatory minimum capital requirements. Bank capital reduces the likelihood of bank failure (if net worth is larger and the bank faces losses, net worth may remain positive).

Capital Adequacy Management High Capital Bank Low Capital Bank Assets Liabilities Assets Liabilities Reserves $10m Deposits $90m Reserves $10m Deposits $96m Loans $90m Bank $10m Loans $90m Bank $ 4m capital capital Now, suppose that there is a bad loan of $5m for both banks, then Loans $85m Bank $ 5m Loans $85m Bank -$ 1m Conclusion: a bank maintains bank capital to lessen the chance that it will become insolvent (bankrupt).

Return on Equity and Bank Capital Higher is bank capital, lower is return on equity (Capital ↑, EM ↓, ROE ↓) Return on Assets (ROA) = net profit after taxes/assets Return on equity (ROE) = net profit after taxes/equity Equity multiplier (EM) = assets/equity capital ROE = ROA × EM Return on equity is higher when bank capital (equity capital) is low Tradeoff between safety (high capital) and ROE

Changes in Bank Capital Banks also hold capital to meet capital requirements If banks choose to increase bank capital relative to assets, they may do so by: Issuing common stock (increasing equity), Reducing dividends to shareholders (adding retained earnings to the capital account), or issuing fewer loans or selling off loans or other assets. and vice versa Capital crunch v.s. Credit crunch in the early 1990s

Managing Credit Risk Reducing impact of adverse selection and moral hazard problems by: (the business of banking is the production of information) Screening Specialization in lending Monitoring and enforcement of restrictive covenants Long-term customer relationships Loan commitments (facilitates long-term relationship) Collateral and compensating balances Credit rationing

Managing Interest Rate Risk First National Bank Assets Liabilities Rate-sensitive assets $20 m Rate-sensitive liabilities $50 m Variable-rate loans Variable-rate CDs Short-term securities MMDAs Fixed-rate assets $80 m Fixed-rate liabilities $50 m Reserves Checkable deposits Long-term bonds Savings deposits Long-term securities Long-term CDs Equity capital

Managing Interest Rate Risk Rate-sensitive assets (liabilities) = assets (liabilities) with interest rates that vary frequently Rate-sensitive assets: variable-rate and short-term loans Rate-sensitive liabilities: variable-rate CDs and money-market deposit accounts Fixed-rate assets (liabilities) = assets (liabilities) with interest rates that remain unchanged for long periods Fixed-rate assets: reserves, long-term loans, long-term securities Fixed-rate liabilities: checkable deposits, savings deposits, long-term CDs, equity capital

Managing Interest Rate Risk If a bank has more rate-sensitive liabilities than assets, an increase in interest rates will reduce its profitability. If a bank has more rate-sensitive assets than liabilities, a decrease in interest rates will reduce its profitability

Managing Interest Rate Risk Gap Analysis GAP = rate-sensitive assets – rate-sensitive liabilities = $20 – $50 = –$30 million When i ↑ 5%: Income on assets = + $1 million (= 5% × $20m) Costs of liabilities = +$2.5 million (= 5% × $50m) △Profits = $1m – $2.5m = –$1.5m = 5% × ($20m – $50m) = 5% × (GAP) △Profits = △i × GAP

Gap Analysis Basic gap = rate-sensitive assets – rate-sensitive liabilities Change in profits = gap × change in interest rate Problem: not all assets and liabilities have the same maturity Maturity bucket approach: measure the gap at several maturity subintervals (maturity buckets) Standardized gap analysis: takes differing degrees of rate sensitivity into account

Duration Analysis (Macaulay) % change in value of security is approximately equal to: －% change in interest rate × duration in years This may be used to find the change in the market value of the bank’s assets and liabilities in response to an interest-rate change.

Duration Analysis Duration Analysis %△ value ≒ –(% point △i) × (DUR) Example: i  5%, duration of bank assets = 3 years, duration of liabilities = 2 years; %△ assets = –5% × 3 = –15% %△ liabilities = –5% × 2 = –10% If total assets = $100 million and total liabilities = $90 million, then assets $15 million, liabilities  $9 million, and bank’s net worth by $6 million Strategies to Manage Interest-rate Risk Rearrange balance-sheet Interest-rate swap Hedge with financial futures

Off-Balance-Sheet Activities Loan sales Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit Trading Activities Financial futures Financial options Foreign exchange Swaps Trading activities and asymmetric information Barrings bank (1995)

Risk Management Principal-Agent Problem Risk Management Controls Traders have incentives to take big risks Risk Management Controls Separation of front and back rooms Value-at-risk modeling Stress testing Regulators encouraging banks to pay more attention to risk management