1. Copyright © 2014 Pearson Canada Inc. Chapter 13 BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS Mishkin/Serletis The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

2. Copyright © 2014 Pearson Canada Inc. 13-2 Learning Objectives 1.Outline a bank’s sources and uses of funds 2.Specify Bank Operation: making profits by accepting deposits and making loans 3.Discuss Risk Management: how bank managers manage credit risk, market risk(interest-rate risk), and operation risk -Explain gap analysis and duration analysis, and CAR as Risk Management tools. 4. Illustrate how off-balance-sheet activities affect bank profits

3. Copyright © 2014 Pearson Canada Inc. 13-3 Assets Reserves Cash Items in Process of Collection Deposits at Other Banks Securities Loans Other Assets

4. Copyright © 2014 Pearson Canada Inc. 13-4 Liabilities Demand and Notice Deposits Fixed-Term Deposits Borrowings –overdraft loans (advances) –settlement balances Bank Capital

5. Copyright © 2014 Pearson Canada Inc. 13-5 Balance Sheet of All Banks in Canada

6. Copyright © 2014 Pearson Canada Inc. 13-6 Basic Banking First Bank makes a loan of $100 to a business and credits the business's chequable deposit Opening of a chequing account leads to an increase in the bank’s reserves equal to the increase in chequable deposits First BankBusiness AssetsLiabilitiesAssetsLiabilities Loans+$100Chequable deposits +$100Chequable Deposits +$100Bank Loans+$100

7. Copyright © 2014 Pearson Canada Inc. 13-7 Basic Banking (cont’d) When a bank receives additional deposits, it gains an equal amount of reserves: when it loses deposits, it loses an equal amount of reserves First Bank AssetsLiabilities Cash items in process of collection +$100Chequable deposits +$100 First BankSecond Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Chequable deposits +$100Reserves-$100Chequable deposits -$100

8. Copyright © 2014 Pearson Canada Inc. 13-8 Basic Banking: Making a Profit Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long First Bank AssetsLiabilitiesAssetsLiabilities Desired reserves +$100Chequable deposits +$100Desired reserves +$10Chequable deposits +$100 Excess reserves +$90Loans+$90

9. Copyright © 2014 Pearson Canada Inc. 13-9 General Principles of Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

10. Copyright © 2014 Pearson Canada Inc. 13-10 Liquidity Management: Ample Reserves First Bank AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital$10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓ If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet

11. Copyright © 2014 Pearson Canada Inc. 13-11 Liquidity Management: Shortfall in Reserves Reserves are a legal requirement and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows First Bank AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital $10M Securities$10MSecurities$10M with deposit outflow of $10 million ↓

12. Copyright © 2014 Pearson Canada Inc. 13-12 Liquidity Management: Borrowing from other Banks Cost incurred is the interest rate paid on the borrowed funds First Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

13. Copyright © 2014 Pearson Canada Inc. 13-13 Liquidity Management: Securities Sale The cost of selling securities is the brokerage and other transaction costs First Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$0M Securities$1MBank Capital$10M

14. Copyright © 2014 Pearson Canada Inc. 13-14 Liquidity Management: Bank of Canada Advances Borrowing from the Bank of Canada also incurs interest payments based on the discount rate First Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$90M Advances Bank of Canada $9M Securities$1MBank Capital$10M

15. Copyright © 2014 Pearson Canada Inc. 13-15 Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount First Bank AssetsLiabilities Reserves$9MDeposits$90M Loans$81M Advances Bank of Canada $0M Securities$10MBank Capital$10M

16. Copyright © 2014 Pearson Canada Inc. 13-16 Asset Management: Three Goals 1.Seek the highest possible returns on loans and securities 2.Reduce risk 3.Have adequate liquidity

17. Copyright © 2014 Pearson Canada Inc. 13-17 Asset Management: Four Tools Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets

18. Copyright © 2014 Pearson Canada Inc. 13-18 Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

19. Copyright © 2014 Pearson Canada Inc. 13-19 Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank Regulatory requirement

20. Copyright © 2014 Pearson Canada Inc. 13-20 Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

21. Copyright © 2014 Pearson Canada Inc. 13-21 Capital Adequacy Management: Returns to Equity Holders

22. Copyright © 2014 Pearson Canada Inc. 13-22 Capital Adequacy Management: Safety Benefits the owners of a bank by making their investment safe 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

23. Copyright © 2014 Pearson Canada Inc. 13-23 Strategies for Managing Bank Capital Lowering Bank Capital: Buying back some of Bank’s stock Pay out higher dividend to shareholders Acquire new funds and increase assets Raising Bank Capital: Issue more common stock Reducing dividend to shareholders Issue fewer loans or sell securities and use proceeds to reduce liabilities

24. Copyright © 2014 Pearson Canada Inc. 13-24 Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis Shortfalls of bank capital led to slower credit growth –Huge losses for banks from their holdings of securities backed by residential mortgages –Losses reduced bank capital Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending

25. Copyright © 2014 Pearson Canada Inc. 13-25 Managing Credit Risk A major component of many financial institutions business is making loans To make profits, these firms must make successful loans that are paid back in full The concepts of moral hazard and adverse selection are useful in explaining the risks faced when making loans

26. Copyright © 2014 Pearson Canada Inc. 13-26 Managing Credit Risk: Adverse Selection Adverse selection is a problem in loan markets because bad credit risks (those likely to default) are the one which usually line up for loans Those who are most likely to produce an adverse outcome are the most likely to be selected

27. Copyright © 2014 Pearson Canada Inc. 13-27 Managing Credit Risk: Moral Hazard Moral hazard is a problem in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful The high risk, however, makes it less likely the loan will be repaid

28. Copyright © 2014 Pearson Canada Inc. 13-28 Managing Credit Risk (cont’d) To be profitable, lending firms must overcome adverse selection and moral hazard problems Attempts by the lending institutions to solve the problems explains a number of principles for managing risk

29. Copyright © 2014 Pearson Canada Inc. 13-29 Managing Credit Risk (cont’d) Screening and Monitoring –Screening –Specialization in Lending –Monitoring and Enforcement of Restrictive Covenants Long-term customer relationships Loan commitments Collateral and compensating balances Credit rationing

30. Copyright © 2014 Pearson Canada Inc. 13-30 Interest Rate Risk If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income

31. Copyright © 2014 Pearson Canada Inc. 13-31 Managing Interest-Rate Risk First National Bank AssetsLiabilities Rate-sensitive assets$20MRate-sensitive liabilities $50M Variable-rate and short-term loansVariable-rate CDs Short-term securitiesMoney market deposit accounts Fixed-rate assets$80MFixed-rate liabilities $50M ReservesCheckable deposits Long-term loansSavings deposits Long-term securitiesLong-term CDs Equity capital

32. Copyright © 2014 Pearson Canada Inc. 13-32 Gap Analysis The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive assets – rate-sensitive liabilities GAP = RSL – RSA A change in the interest rate (Δi) will change bank income (  depending on the Gap  Income = GAP   i

33. Copyright © 2014 Pearson Canada Inc. 13-33 Duration Analysis (cont’d) Owners and managers care not only about the change in interest rates on income but also on net worth of the institution Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates

34. Copyright © 2014 Pearson Canada Inc. 13-34 Duration Analysis (cont’d) %ΔP = - DUR x [Δi/(1+i)] Where: P is the market value %ΔP = (P t+1 – P t )/P DUR = duration i = interest rate

35. Copyright © 2014 Pearson Canada Inc. 13-35 Duration Analysis (cont’d) The Duration Gap can be calculated as: DUR gap = Dur a – (L/A x DUR L ) Where: Dur a = average duration of assets L = market value of liabilities A = market value of assets Dur l = average duration of liabilities

36. Copyright © 2014 Pearson Canada Inc. 13-36 Off-Balance-Sheet Activities Loan sales (secondary loan participation) Generation of fee income Trading activities and risk management techniques –Futures, options, interest-rate swaps, foreign exchange –Speculation

37. Copyright © 2014 Pearson Canada Inc. 13-37 Off-Balance-Sheet Activities (cont’d) Trading activities and risk management techniques –Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation –Principal-agent problem arises

38. Copyright © 2014 Pearson Canada Inc. 13-38 Off-Balance-Sheet Activities (cont’d) Internal controls to reduce the principal-agent problem –Separation of trading activities and bookkeeping –Limits on exposure –Value-at-risk –Stress testing