Copyright© 2006 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University

CHAPTER 14 BANK MANAGEMENT AND PROFITABILITY

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4 Bank Earnings: Net Interest Income Loan interest and fees represent the main source of bank revenue, followed by interest on investment securities. Interest paid on deposits is the largest expense, followed by interest on other borrowings. Net interest income is the difference between gross interest income and gross interest expense. This margin is relatively stable because the interest rates banks earn and pay are largely set by the market.

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6 Bank Earnings: Provision for Loan Losses Provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account). Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio. Loans are written off against the loan loss reserve

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8 Bank Earnings: Non-interest income and expense Noninterest income includes fees and service charges. This source of revenue has grown significantly in importance. Noninterest expense includes personnel, occupancy, technology, and administration. These expenses have also grown in recent years.

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10 Bank Performance Trends in profitability can be assessed by examining return on average assets (net income / average total assets) over time. Another measure of profitability is return on average equity. In the mid- and late-1990s, bank profitability improved significantly.

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Copyright© 2006 John Wiley & Sons, Inc.12 Dilemma: Profitability vs. Safety One way for a bank to increase expected profits is to take on more risk. However, this can jeopardize bank safety. For a bank to survive, it must balance the demands of three constituencies: shareholders depositors regulators Each with their own interest in profitability and safety.

Copyright© 2006 John Wiley & Sons, Inc.13 Solvency and Liquidity Solvency: Maintaining the momentum of a going concern, attracting customers and financing. A firm is insolvent when the value of its liabilities exceeds the value of its assets. Banks have relatively low capital/asset ratios but generally high-quality assets. Liquidity: the ability to fund deposit withdrawals, loan requests, and other promised disbursements when due. A bank can be profitable and still fail because of illiquidity.

Copyright© 2006 John Wiley & Sons, Inc.14 Conflicting Demands A bank must balance profitability, liquidity, and solvency. Bank failure can result from excessive losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable. Failure can also occur if a bank cannot meet liquidity demands. If assets are profitable but illiquid, the bank also has a problem. Bank insolvency often leads to bank illiquidity.

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Copyright© 2006 John Wiley & Sons, Inc.16 Liquidity Management Banks rely on both asset sources of liquidity and liability sources of liquidity to meet the demands for liquidity. The demands for liquidity include accommodating deposit withdrawals, paying other liabilities as they come due, and accommodating loan requests.

Copyright© 2006 John Wiley & Sons, Inc.17 Asset Management classifies bank assets from very liquid/low profitability to very illiquid/profitable Primary Reserves are noninterest bearing, extremely liquid bank assets Secondary Reserves are high-quality, short-term, marketable earning assets Bank Loans are made after absolute liquidity needs are met After loan demand is satisfied, funds are allocated to Income Investments that provide income, reasonable safety, and some liquidity, if needed

Copyright© 2006 John Wiley & Sons, Inc.18 Asset Management (cont.) The bank must manage its assets to provide a compromise of liquidity and profitability. Primary and secondary reserve levels relate to: deposit variability other sources of liquidity (e.g. Fed funds) bank regulations - permissible areas of investment risk posture that bank management will assume

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Copyright© 2006 John Wiley & Sons, Inc.20 Liability Management Assumes bank can borrow its liquidity needs at will in money markets by paying market rate or better Liability levels (borrowing) may be quickly adjusted to loan (asset) needs or deposit variability Bank liability liquidity sources include “non- deposit borrowing" (e.g. Fed funds, etc.) LM supplements asset management, but does not supersede it

Copyright© 2006 John Wiley & Sons, Inc.21 Definition of Bank Capital Tier 1 capital or “core” capital includes common stock, common surplus, retained earnings, non- cumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets. Tier 2 capital or “supplemental” capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures.

Copyright© 2006 John Wiley & Sons, Inc.22 Functions of Bank Capital Absorb losses on assets (loans) and limit the risk of insolvency. Maintain confidence in the banking system. Provide protection to uninsured depositors and creditors. Ultimate source of funds and leverage base to raise depositor funds.

Copyright© 2006 John Wiley & Sons, Inc.23 Regulatory Capital Standards As capital requirements have increased, regulators have also implemented risk-based capital standards. Capital is measured against risk-weighted assets. Risk-weighting is a measure of total assets that weighs high-risk assets more heavily. The purpose is to require high-risk banks to hold more capital than low-risk banks.

Copyright© 2006 John Wiley & Sons, Inc.24 Minimum Capital Requirements Ratio of Tier 1 capital to risk-weighted assets must be at least 4% Ratio of Total Capital (Tier 1 plus Tier 2) to risk-weighted assets must be at least 8%. Undercapitalized banks receive extra regulatory scrutiny; regulators may limit activities, intervene in management, or even revoke charter.

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Copyright© 2006 John Wiley & Sons, Inc.28 Managing Credit Risk The credit risk of an individual loan concerns the losses the bank will experience if the borrower does not repay the loan. The credit risk of a bank’s loan portfolio concerns the aggregate credit risk of all the loans in the bank’s portfolio. Banks must manage both dimensions effectively to be successful.

Copyright© 2006 John Wiley & Sons, Inc.29 Managing Credit Risk of Individual Loans Begins with lending decision (and 5 Cs as discussed in Chapter 13) Requires close monitoring to identify problem loans quickly The goal is to recover as much as possible once a problem loan is identified.

Copyright© 2006 John Wiley & Sons, Inc.30 Managing Credit Risk of Loan Portfolio Internal Credit Risk Ratings are used to identify problem loans determine adequacy of loan loss reserves price loans Loan Portfolio Analysis is used to ensure that banks are well diversified. Concentration ratios measure the percentage of loans allocated to a given geographic location, loan type, or business type.

Copyright© 2006 John Wiley & Sons, Inc.31 Measuring Interest Rate Risk: Maturity GAP Analysis Assets and liabilities which “reprice” (change interest rate in a specified period of time) are identified as “rate- sensitive”. A bank's Maturity GAP is computed by subtracting rate sensitive liabilities (RSL) from rate sensitive assets (RSA).

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Copyright© 2006 John Wiley & Sons, Inc.34 GAP = RSA – RSL; Positive Gap Positive GAP = RSA > RSL Net interest income will decline if interest rates fall More assets than liabilities reprice downward if interest rates decline, thus reducing net interest income

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Copyright© 2006 John Wiley & Sons, Inc.36 GAP = RSA – RSL; Negative Gap Negative GAP = RSA < RSL Net interest income will decline if interest rates increase More liabilities than assets reprice upward if interest rates increase, thus reducing net interest income.

Copyright© 2006 John Wiley & Sons, Inc.37 Managing Interest Rate Risk:Duration GAP Analysis Maturity GAP provides only an approximate rule for analyzing interest rate risk. Duration GAP analysis matches cash flows and their repricing capabilities over a period of time. The percentage change in the value of a portfolio, given a change in interest rates, is proportional to the duration of the portfolio multiplied by the change in interest rates.

Copyright© 2006 John Wiley & Sons, Inc.38 Managing Interest Rate Risk: Duration GAP Formula WhereD G = duration gap D A = duration of assets D L = duration of liabilities MV A = market value of assets MV L = market value of liabilities Duration GAPs are opposite in sign from maturity GAPs for the same risk exposure.

Copyright© 2006 John Wiley & Sons, Inc.39 Positive Duration GAP Assets have longer duration than liabilities; bank expects interest rates to fall If interest rates rise— More assets than liabilities will lose value, Thus reducing the value of the bank’s equity If interest rates fall- More assets than liabilities will gain value, Thus increasing the value of the bank’s equity

Copyright© 2006 John Wiley & Sons, Inc.40 Negative Duration GAP Liabilities have longer duration than assets; bank expects interest rates to rise. If interest rates rise— More liabilities than assets will lose value, Thus increasing the value of the bank’s equity If interest rates fall— More liabilities than assets will gain value, Thus reducing the value of the bank’s equity

Copyright© 2006 John Wiley & Sons, Inc.41 Zero Duration Gap Bank is immunized against interest rate risk. Easier in theory than in practice. Duration GAP manipulation is a complex tool, used more by large banks.

Copyright© 2006 John Wiley & Sons, Inc.42 Hedging Interest Rate Risk: Asset-Sensitive Asset-sensitive with positive maturity GAP; negative duration GAP; hurt by falling rates: Buy financial futures--falling rates increase value of contract, offsetting negative impact of GAP Buy call options on financial futures Swap to increase their variable-rate cash outflows and increase their fixed-rate (long-term) cash inflows Lengthen repricing of assets; shorten repricing of liabilities

Copyright© 2006 John Wiley & Sons, Inc.43 Hedging Interest Rate Risk: Liability-Sensitive Liability-sensitive with negative maturity GAP; positive duration GAP;--hurt by rising rates: Sell financial futures--increasing rates would increase value of futures contracts, offsetting the negative impact of GAP situation Buy put options on financial futures Swap long-term, fixed-rate payments for variable-rate payments Shorten repricing of assets; lengthen repricing of liabilities

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