Lecture 18: Bank risk management Mishkin Ch 9 – part B page 229-246

Outline: Liquidity Management Asset Management Liability Management enough cash and liquidity assets to pay depositors Asset Management diversifying investment Liability Management low cost of getting funds Capital Adequacy Management required by regulators manage credit risk manage interest-rate risk manage risks in off-balance-sheet activities 2 2

Asset management Goal of asset managements is to seek the highest returns possible subject to minimizing risk and making adequate provisions for liquidity. Find good quality borrowers Purchase securities optimally Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets.

Liability management Target: acquire funds with low costs. The old way: checkable deposits New trend since 1960s: borrow funds in overnight loan markets (e.g. fed funds market) New financial instruments (e.g. negotiable CDs)

Capital adequacy management Why capital adequacy is beneficial? Bank capital is a cushion that helps prevent bank failure. Regulatory requirement. Why might banks want to hold less bank capital? The amount of capital affects return for the owners (equity holders) of the bank.

Prevent bank failure Bank failure: a bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its reserve requirements . Holding adequate bank capital helps prevent bank failures because it can be used to absorb the losses resulting from a deposit outflow.

Prevent bank insolvency insolvent: liabilities > assets  neg. net worth Bank capital decrease the chance of insolvency. High Bank Capital Low Bank Capital Assets Liabilities Reserves $10M Deposits $90M $96M Loans Bank Capital $4M $85M $5M -$1M Loan written offs

Returns to equity holders Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank.

Safety – ROE tradeoff Increase bank capital is: benefit to the owners of a bank by making their investment safe (avoid bank failure). costly to owners of a bank because the higher the bank capital, the lower the return on equity. Choice depends on the state of the economy and levels of confidence. e.g. in more uncertain times, when the possibility of large losses on loans increases, bankers might want to hold more bank capital.

Managing credit risk Adverse selection and moral hazard between the bank and investors  credit risk (risk that loans not paid back in full) Measures: Screening and monitoring screening and information collection specialization in lending monitoring and enforcement of restrictive covenants

Managing credit risk – cont’d Measures (cont’d) Long-term customer relationships Loan commitments Collateral and compensating balances Credit rationing 11 11

Interest-rate risk - example Bank Assets Liabilities Rate-sensitive assets $20M Rate-sensitive liabilities $50M Fixed-rate assets $80M Fixed-rate liabilities $40M Interest rate increase 5%  interests earned from asset increase $1M, interest cost from liabilities increase $2.5M  profit decrease $1.5M If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits .

Gap analysis GAP = rate-sensitive assets – rate-sensitive liabilities Profits = i  GAP When interest rate increase 5%: GAP = $20 – $50 = –$30 million Profits = 5%  ( – $30m) = –$1.5m 13

Duration analysis Duration is the average lifetime of a security’s stream of payments. 14

Duration analysis - example Suppose: Bank assets is $100M and liabilities is $90M duration of bank assets is 3 years duration of liabilities is 2 years; Now: interest rate increase 5%, Calculate: % assets = –5%  3 = –15% % liabilities = –5%  2 = –10% assets value decrease$15M, liabilities decrease $9M bank’s net worth decrease $6M 15

Managing interest-rate risks GAP analysis focus on interest gain (loss) from asset and liabilities that are most sensitive to interest rate changes. Duration analysis examines the sensitivity of the market value of the bank’s total assets and liability to interest-rate changes. Need to adjust holdings of assets and liabilities to reduce interest rates risk when risks are too high. 16

Off-balance-sheet activities Loan sales (secondary loan participation) Generation of fee income Examples: servicing mortgage-backed securities, guarantees of debt, etc. Trading activities Examples: futures market trading Principal-agent problem

Managing risk in off-balance-sheet activities Internal controls: Separation of front and back rooms Limit risky exposure Value-at-risk modeling Stress testing