CHAPTERS 19, 20 1

Bank Profits   = Loans x Realized Loan Yield - Deposits x Cost per $ of Deposits - Fixed Expenses  RLY = Contractual rate x Good Loan Fraction - (1-Recov. rate) x Bad Loan Fraction  Cost of Deposits = Interest paid plus the cost of free services  Fixed Costs = the cost of everything else the bank needs to run the business 2

B. Realized Loan Yield Example  RLY = Contractual rate x Good Loan Fraction - (1-Recov. rate) x Bad Loan Fraction  Consider an average rate of 12%, 90% good loans and a recovery rate of 85% on bad loans. The RLY in this example is 9.3%  RLY =.12 x.9 - (1-.85) x.10 =.093 or 9.3%  If the bank has a $100,000,000 portfolio, that equates to $9,300,000 in interest income after writing off $1,500,000 in bad loan losses (against $10,800,000 interest income)

C. Return on Equity: ROE = Profits / Equity D. Methods of Increasing ROE  Lower Equity (increase leverage); a risky move in a volatile environment – especially during periods of low profitability  Equity Ratio = equity / loans and investments 4

3.Raise Profits by increasing revenue:  Increase contractual rates  Lend more money; need to increase deposits,  Decrease free services or start charging for them  Lower variable costs  Lower fixed costs; problem of indivisibility  Tighten loan standards; could result in lowering total loan portfolio  Offer other low-cost high margin services; i.e., brokerage, insurance, etc  Increasing size to get benefits of scale  Securitizing collateralized loans; retaining servicing fee income 5

E. Market Considerations  Competition limits ability to raise loan rates, reduce services, or reduce deposit rates  Increasing loan rates and decreasing deposit rates increases the Net Interest Margin  Ability to make loans a function of; (1) excess reserves or (2) required reserve ratio  Customers know more than the bank  Problem of asymmetric information  Adverse selection; raise rates and best quality customers may leave 6

F. The Risk-Return Tradeoff  Competition and adverse selection limit ability to increase earnings from lending  Other investments offer higher returns but carry interest rate risk;  Rather than lending, could invest depositors cash in interest earning securities  As interest rates change, value of the investment portfolio changes  What happens when value of the assets are less that value of liabilities? G. A Final Pass on Deposits, Reserves, and Liquidity  Increasing deposits also increases variable costs  Ability to make loans a function of excess reserves (cash in vault: opportunity cost)  Liquidity is necessary to service client demand for cash 7

Banking Regulation Seeks to Reduce Financial Shocks  Banks must have higher levels of capital; BIS (Bank for International Settlements)  Tier 1: Book Value of Stock plus retained earnings  Tier 2: Sum of Loan-Loss reserves and subordinated debt  Total capital = Tier 1 plus Tier 2  How much a bank must have in each category a function of risk-adjusted assets  Risk-Weighted Capital Requirements and Asset Types;  Cash and Government Securities = 0 risk weight  Loans = 1.0 risk weight  Mortgages = 0.5 weight  Inter bank deposits = 0.2 weight 8

3.The [Separate] Leverage Requirement  Tier 1 capital; 3% of all unweighted assets  If risky, may require 4-6% 4.Off-Balance Sheet assets not counted 9

B. Bank Response to New Capital Requirements  Issuance of new stock  Merger with a stronger bank  Shrinking the Balance Sheet.; reduction in assets, w/o changes in equity, increases equity ratio orpushing for acquisition by larger bank  Risk weights increase attractiveness of Government securities. (also subjects them to interest rate risk)  Shifting from riskier assets within each category  Take on more interest- and exchange-rate risk  Take on risk as Forward Intermediary; i.e., selling derivatives 10

The Most Frequently Given Reasons for Bank Failure  Bank officer fraud  Excessive Bad Loans  Inadequate Liquidity / Inadequate Capital  Deregulation leading to Increase in Competition  Regulatory forbearance  Non preparedness for increase in interest rate risk 11

Examining the Proportion of Rate Sensitive Assets and Liabilities  GAP Analysis → Changes in Income  GAP = Rate Sensitive Assets (RSA) – Rate Sensitive Liabilities (RSL)   I = GAP *  i 2.Rate Sensitive Assets:  Short-Term Loans (Maturities 1 year or less); commercial or consumer  Variable Rate Mortgages  The proportion of fixed rate mortgages that are repaid early  The proportion of auto loans paid early 3.Rate Sensitive Liabilities  Money Market Deposits  Variable Rate CDs and CDs maturing in 1 year or less  Borrowings with maturities 1 year or less 12

B. Interest Rate Changes and GAP  If a financial institution has more rate sensitive liabilities (RSL) than rate sensitive assets (RSA), then the GAP will be negative:  GAP = RSA – RSL  If RSL > RSA, then GAP < 0 (negative)  Any increases in Interest rates will reduce the GAP (or net interest rate margin) and result in net income decline: 13

C. Bank Profits a function of interest rate expectations  If interest rates expected to go up, then allocate assets to short-term loans → rollover at higher rates  If interest rates expected to go down, allocate assets to long-term loans → less rollover D. Forecasting interest rates is important  Effects on GAP of Proportions of RSA and RSA  Magnitude of excess reserves is key to loss containment strategy 14

E. Types of SWAPS:  Fixed rate for Floating Rate Swap: rates calculated at time of swap  Forward Swap; setting the rates now for future swap  Swaptions: hybrid arrangements for early termination  Callable Swap: party making fixed payments option to terminate before maturity [Desirable if interest rates decline]  Putable Swap: party making floating payments option to terminate before maturity [Desirable if interest rates increase] F. Basis Risk in Swap Transactions  Recall that gains and losses for parties to a futures-type arrangement stem from  Changes in basis  If fixed rates go up more slowly than variable rates, basis decreases resulting in increases to the buyer (institution exchanging or paying fixed rate for variable.) 15

Forecasting interest rates is important  Proportions of RSA and RSL - GAP  Magnitude of excess reserves is key to loss containment strategy Fixed Yields on Loan Portfolios, Variable Costs of Liabilities  Assets and Liabilities tend to be rate sensitive  Allocation of bank resources (assets) a function of interest rate expectations  If interest rates expected to go up, allocate assets to short-term loans  Rollover at higher rates  If interest rates expected to go down, allocate assets to long-term loans  Less rollover  Cost of liabilities (deposits) tends to be very rate sensitive  The Gap between the Yields on Assets and the Implicit Costs of Liabilities sensitive to changes in asset maturity and deposit turnover 16

C. Potential Strategies  Maturity matching; would drive Commercial banks to short-term loans  Floating-rate loans; unpopular with borrowers  Financial Futures; high leverage, high risk (basis risk)  Interest Rate Swaps; potentially risky if wrong on expectations or arrangements  The Interest Rate Swap:  Dealing with changes induced in Interest Revenues and Interest Expense resulting from changes in market rates D. The Scenarios for Interest rate Swaps  Long-Run increase in interest rates; decreases the gap  Long-Run decrease in interest rates; increases the gap 17

How are depository institutions' profits determined? How does the bank realized loan yield (RLY) affected by credit policies? If a bank has low ROE (or ROA), what strategies might it pursue? What determines the ability of a bank to expand loan activity? What is meant by Adverse Selection? How does it affect bank operations? How have banks responded to the capital requirements under the BIS standard? What is the single largest source of risk for banks? What are Swaps and how do banks use them? What are the ways banks can increase their profits? What are the two biggest dangers they face in doing so? Why are banks trying to get larger and to expand their activities? Q&A 19: 3, 4, 7, 8, 10, Q&A 20: 1, 4, 8, 9 18