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 how banks make profits by accepting deposits and making loans 3.Discuss how bank managers manage credit risk and interest-rate risk 4.Explain gap analysis and duration analysis 5.Illustrate how off-balance-sheet activities affect bank profits

3. Copyright © 2014 Pearson Canada Inc. 13-3 Balance Sheet of All Banks in Canada

4. Copyright © 2014 Pearson Canada Inc. 13-4 Basic Banking Principle A Bank collects Capital, Paid by shareholders; keeps it as fractional Reserves, in the form of cash or securities, for Liquidity against Cash Withdrawal, and make a multiplied amount of loans(Assets) by creating the equal amount of bank money(demand deposit) in the borrowers’ checking account balances(Liablities). Its interest income comes from the Net Interest Margin(NIM) or difference between loan rates for Assets and deposit rates for Liabilities. The net profits belongs to Shareholder. The profits can be distributed as dividends or be retained within the bank.

5. Copyright © 2014 Pearson Canada Inc. 13-5 General Principles of Bank Management Asset Management Liability Management – Funding Risk Management Management of Credit Risk + Operation Risk + Market Risk through Internal Capital Adequacy Assessment Process(ICAAP) for Capital Adequacy Requirements(CAR) Management of Other Risks such as Liquidity Risk, Interest Rate Risk, Reputational Risk, Strategic Risk.

6. Copyright © 2014 Pearson Canada Inc. 13-6 Asset Management: Three Goals 1.Seek the highest possible returns on loans and securities 2.Reduce risk 3.Have adequate liquidity

7. Copyright © 2014 Pearson Canada Inc. 13-7 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

8. Copyright © 2014 Pearson Canada Inc. 13-8 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

9. Copyright © 2014 Pearson Canada Inc. 13-9 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

10. Copyright © 2014 Pearson Canada Inc. 13-10 Risk types according to the ICAAP process Risk type Pillar 1Pillar 2 Capital is allocated Contributes to calculated capital need? Credit riskYes Concentration riskNoYes Market riskYesYes, plus additional tests Market risk Interest rate risk in banking book NoYes, plus additional tests Operational riskYes Business risk: Earnings volatility riskNoYes Risks in retirement benefitsNoYes Strategic risk: Business plansNoYes No specific capital is allocated Identified and mitigated? Reputational risk No Yes Liquidity risk No Yes, stress test Strategic risk: Decision risk No Yes Measurement In addition to Pillar 1 risks, the newly revised ICAAP encompasses risks for which no capital is allocated, such as business risk, pension risk, and strategic risk. * source: Swedbank ’ s ICCAP

11. Copyright © 2014 Pearson Canada Inc. 13-11

12. Copyright © 2014 Pearson Canada Inc. 13-12 Bank Performance Measures: Returns to Capital paid by Equity Holders

13. Copyright © 2014 Pearson Canada Inc. 13-13 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

14. Copyright © 2014 Pearson Canada Inc. 13-14 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

15. Copyright © 2014 Pearson Canada Inc. 13-15 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

16. Copyright © 2014 Pearson Canada Inc. 13-16 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

17. Copyright © 2014 Pearson Canada Inc. 13-17 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 gap i = interest rate

18. Copyright © 2014 Pearson Canada Inc. 13-18 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

19. Copyright © 2014 Pearson Canada Inc. 13-19 Change in Net Worth Formula  NW/ A = - DUR gap x  i/1+i)

20. Copyright © 2014 Pearson Canada Inc. 13-20 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

21. Copyright © 2014 Pearson Canada Inc. 13-21 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

22. Copyright © 2014 Pearson Canada Inc. 13-22 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