1. Management of Banking and Financial Institutions Chapter 9

2. Overview The Bank Balance Sheet Asset Management Liability Management Capital Adequacy Management Managing Interest Rate Risk Financial Innovations The Bank Balance Sheet Asset Management Liability Management Capital Adequacy Management Managing Interest Rate Risk Financial Innovations

3. How do banks make money? Take in liabilities with certain characteristics Short term Low interest rate Liquid deposits Convert to loans with different characteristics Long term Higher Interest Rate Less liquid loans Total Assets = Total Liabilities + Bank Capital Take in liabilities with certain characteristics Short term Low interest rate Liquid deposits Convert to loans with different characteristics Long term Higher Interest Rate Less liquid loans Total Assets = Total Liabilities + Bank Capital

4. Liabilities Checkable deposits Nontransaction deposits CDs, savings accounts Borrowings Fed Reserve Bank to bank Parent Company Repurchase agreements (Repos) Eurodollars Bank Capital (Net worth) Stock Checkable deposits Nontransaction deposits CDs, savings accounts Borrowings Fed Reserve Bank to bank Parent Company Repurchase agreements (Repos) Eurodollars Bank Capital (Net worth) Stock

5. Assets Cash items Reserves: Required and Excess Cash items in process of collection Deposits at other banks Securities (10% of revenue) Federal, state, and local Loans (over 50% of revenue) Illiquid, long term, so higher interest Other Assets (physical capital) Cash items Reserves: Required and Excess Cash items in process of collection Deposits at other banks Securities (10% of revenue) Federal, state, and local Loans (over 50% of revenue) Illiquid, long term, so higher interest Other Assets (physical capital)

6. The T-account Accounting scheme Role of reserves Reserve ratio Excess reserves Liquidity What to do when reserves get too low? Borrow (Fed or other banks) Sell securities Call loans Balance! Accounting scheme Role of reserves Reserve ratio Excess reserves Liquidity What to do when reserves get too low? Borrow (Fed or other banks) Sell securities Call loans Balance!

7. Asset management Borrow short and lend long High return Low cost and low risk Liquidity (enough deposit outflows) Examples Long term loans to reliable customers Reliable high interest securities Diversify Borrow short and lend long High return Low cost and low risk Liquidity (enough deposit outflows) Examples Long term loans to reliable customers Reliable high interest securities Diversify

8. Liability Managment Demand deposits before 1960, over 60% of inflow from dd Now only 9%!!! Loans 1960 was 2%, 2002 was 42%, now 56% CDs especially Savings accounts Banks now manage their liability side! E.g. control size based on how many loans they thing they can make Demand deposits before 1960, over 60% of inflow from dd Now only 9%!!! Loans 1960 was 2%, 2002 was 42%, now 56% CDs especially Savings accounts Banks now manage their liability side! E.g. control size based on how many loans they thing they can make

9. Bank Capital Adequacy Mgmt Capital (on liability side) is net worth Prevents insolvency (bank failure) Satisfies regulators (8% min) How do they do reduce (increase) BC? Buy (sell) stock Increase (decrease) dividends Increase (decrease) assets relative to BC, e.g. borrow or loan more money Capital (on liability side) is net worth Prevents insolvency (bank failure) Satisfies regulators (8% min) How do they do reduce (increase) BC? Buy (sell) stock Increase (decrease) dividends Increase (decrease) assets relative to BC, e.g. borrow or loan more money

10. Tradeoff: Safety vs. Profits How to balance Good times, keep K low Bad times, keep K high Savings and loan crisis, require more K But couldnt increase K because couldnt sell stock! Had to lower lending (increase in relative K) How to balance Good times, keep K low Bad times, keep K high Savings and loan crisis, require more K But couldnt increase K because couldnt sell stock! Had to lower lending (increase in relative K)

11. Tradeoff: safety vs. profits Return on assets (ROA) - Measure of efficiency Net profits after taxes/assets Return on equity (ROE) - Profitability measure Net profits after taxes/equity (bank) capital Equity Multiplier (EM) ROE/ROA How much a return on assets translates into a return on equity Return on assets (ROA) - Measure of efficiency Net profits after taxes/assets Return on equity (ROE) - Profitability measure Net profits after taxes/equity (bank) capital Equity Multiplier (EM) ROE/ROA How much a return on assets translates into a return on equity

12. Managing Credit Risk How do banks get high interest, honest customers? Screen/monitor (covenants, specialize, size etc.) Long-term relationships Compensating balances Collateral Lines of credit Restrict credit (example: adj. rate mortgages) How do banks get high interest, honest customers? Screen/monitor (covenants, specialize, size etc.) Long-term relationships Compensating balances Collateral Lines of credit Restrict credit (example: adj. rate mortgages)

13. Managing Interest Rate Risk Changing interest rates affect assets and liabilities Affects variable AND fixed assets/liabilities A change in IR affects variable rates and hence directly affects cash flow into assets and payments to liabilities A change in IR affect affects fixed rated by its relative gain or loss, e.g. what the bank COULD be making (or losing) if the asset or liability wasnt fixed Changing interest rates affect assets and liabilities Affects variable AND fixed assets/liabilities A change in IR affects variable rates and hence directly affects cash flow into assets and payments to liabilities A change in IR affect affects fixed rated by its relative gain or loss, e.g. what the bank COULD be making (or losing) if the asset or liability wasnt fixed

14. Gap Analysis Measures sensitivity to interest rates For Variable Interest Assets and Liabilities Profits = (var.assets - var.loans)(%pointir) What if… A bank has more variable liabilities than assets The interest rate decreases Measures sensitivity to interest rates For Variable Interest Assets and Liabilities Profits = (var.assets - var.loans)(%pointir) What if… A bank has more variable liabilities than assets The interest rate decreases

15. Duration Analysis Duration measures a weighted lifetime average of the stream of payments Applies to fixed interest assets/liabilities $ Net worth = (-1)(I)(Da)(FixedA) - (-1)(I)(Dl)(FixedL) What if… Duration of liabilities is more than assets Interest rate decreases Duration measures a weighted lifetime average of the stream of payments Applies to fixed interest assets/liabilities $ Net worth = (-1)(I)(Da)(FixedA) - (-1)(I)(Dl)(FixedL) What if… Duration of liabilities is more than assets Interest rate decreases

16. Strategies to manage IR risk Diversify! Stay ahead of the curve Financial Derivatives (innovations) Forwards Futures Options Swaps Diversify! Stay ahead of the curve Financial Derivatives (innovations) Forwards Futures Options Swaps

17. Off Balance Sheet Activities Income from these has doubled since 1980 Loan Sales Ginnie Mae, Fannie Mae, Freddie Mac Generate Fees Foreign exchange trading charges Bankers acceptances (like a co-signer) Lines of credit Servicing securitization of mortgages Trading Activities Futures, options, interest-rate swaps Income from these has doubled since 1980 Loan Sales Ginnie Mae, Fannie Mae, Freddie Mac Generate Fees Foreign exchange trading charges Bankers acceptances (like a co-signer) Lines of credit Servicing securitization of mortgages Trading Activities Futures, options, interest-rate swaps

18. Trading Risk Management Barings, now Societe Generale Value at risk Probability of maximum loss in a given time period Example max possible loss in 1 month= 1 million Loss that big could only happen every two years Value at risk is 1/24 at 1 million dollars Stress testing (looking for domino effects) Barings, now Societe Generale Value at risk Probability of maximum loss in a given time period Example max possible loss in 1 month= 1 million Loss that big could only happen every two years Value at risk is 1/24 at 1 million dollars Stress testing (looking for domino effects)