1. 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

2. 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)

3. The Bank Balance Sheet
The Bank Balance Sheet

4. 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.

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

6. 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)

7. 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

8. 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.

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

10. 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 Checkable deposits
Excess reserves
Loans

11. 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 Checkable deposits
Loans

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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.

18. 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.

19. 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 Checkable deposits were 61% of liabilities in 1960, but were 9% in 2002.

20. 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).

21. 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).

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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.

31. 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

32. 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)

33. 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