Post on 22-Dec-2015
CHAPTER
1919Bank
Management
© 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter Objectives
Describe the underlying goal of bank management
Discuss how banks manage liquidity Evaluate how banks manage interest rate risk Look at the techniques to manage credit risk Explain how banks manage capital
Goal of Bank ManagementGoal of Bank Management
The underlying goal of bank management is to maximize the wealth of the bank’s shareholders Maximizing the share price Agency costs
Investor costs incurred to promote managers’ interest in serving investors’ interest
Managers need incentives to seek shareholder’s best interests
Takeover target if stock price undervalued
Risks Faced By BanksRisks Faced By Banks
Value ofBank
Credit Risk
Interest RateRisk
LiquidityRisk
ValueRelated to
Cash Flowsand
Risk ofCash Flows
Capital orInsolvency
Risk
MarketRisk
Managing Liquidity RiskManaging Liquidity Risk
Risk of variability of return impacted by cost of providing liquidity for deposit outflows and/or loan demand
Maintain liquid assets and ability to borrow in financial markets
Securitizing loans provide liquidity Must forecast future cash flows
Managing LiquidityManaging Liquidity
Use of securitization to boost liquidity Selling off loans to trustee
Mortgage and automobile loans Trustee issues securities collateralized by the assets Loan payments pass through to holders of securities
Securitization turns future cash flows into immediate cash
Risk level related to guarantee provided to trust
Managing Interest Rate RiskManaging Interest Rate Risk
Risk of variability of returns caused by changing market interest rates
Interest rate risk comprised of price risk and reinvestment risk
Price risk = variability of returns caused by varying prices of assets
Security and loan values vary inversely with changes in market rates
Managing Interest Rate RiskManaging Interest Rate Risk
Reinvestment risk = variability of return caused by changing interest rates on the reinvested coupon of securities or loans
Reinvestment risk and price risk cause realized returns to vary from expected
Price risk and reinvestment risk have an opposite impact on realized return when market interest rates change
Managing Interest Rate RiskManaging Interest Rate Risk
Causes variability in net interest income (NII) and net interest margin (NIM)
NII = interest income - interest expense NIM = NII/assets Varying interest rates impact value of
financial assets, liabilities, and reinvestment returns
Varying interest rates cause repricing of loans, securities, and deposits impacting NII
Measuring Interest Rate RiskMeasuring Interest Rate Risk
$GAP measurement Duration measurement Regression analysis Benefits and limitations of each
$GAP easily constructed Duration measure more accurate Regression depends on future consistent
relationship of variables
GAP MeasurementGAP Measurement
$GAP = rate sensitive or repriceable assets (RSA) for a time period - rate sensitive liabilities (RSL)
Measures varied repriceability of interest-bearing assets, liabilities, and the cash flows of each
$GAP ratio = RSA - RSL +$GAP = asset sensitive position -$GAP = liability sensitive position
GAP, Varying Rates, NII AND NIMGAP, Varying Rates, NII AND NIM
+ $GAP - $GAP 0 $GAP
RSA > RSL RSA< RSL RSA = RSL
Interest Rates
Interest Rates
Interest Rates
Net Interest Income
Net Interest Income
Stable NetInterest Inc.
Duration MeasurementDuration Measurement
Adds consideration of cash flow, time value, and repricing
Duration = sum of discounted, time-weighted cash flows divided by the price of security or loan
Duration measures time-weighted maturity
Duration a better measure of risk than $GAP
Managing Interest Rate RiskManaging Interest Rate Risk
Duration measurement Captures different degrees of sensitivity to interest
rate changes E.g. a 10-year zero coupon bond is more interest-
sensitive than a 10-year coupon bond Shorter maturities; lower duration Coupon interest and loan payments shorten duration
Duration of each type of bank asset and liability is determined
DURGAP = DURAS – [DURLIAB x LIAB/AS]
Managing Interest Rate RiskManaging Interest Rate Risk
Regression analysis Estimates the historical relation between interest rates
and bank performance R = B0 + B1Rm + B2i + u
B2 = interest rate coefficient Positive coefficient suggests that past performance is
positively affected by rising interest rates Research suggest the opposite is true
Banks and S&L’s tend to have a negative gap NII and NIM adversely impacted with increasing interest rates
Managing Interest Rate RiskManaging Interest Rate Risk
Determining whether to hedge interest rate risk Banks often use all three methods Banks use their analysis of gap with interest rate forecasts
to make their hedging decision
Methods of reducing interest rate risk Maturity matching of loans and deposits Using floating-rate loans Using interest rate futures contracts Using interest rate swaps Using interest rate caps
Managing Interest Rate RiskManaging Interest Rate Risk
Methods of reducing interest rate risk Maturity matching
Match each deposit’s maturity with an asset of the same maturity
Difficult to implement Lots of short-term deposits
Using floating-rate loans Often increases credit risk and liquidity risk
Managing Interest Rate RiskManaging Interest Rate Risk
Methods of reducing interest rate risk Using interest rate futures contracts
E.g. sale of T-bond futures by negative GAP bank to hedge interest rate increase results in a futures gain, offsetting adverse effects on NII
Hedging locks in NIM and negates benefit of falling rates. What about futures options?
Using interest rate swaps Arrangement to exchange periodic cash flows based on specific
interest rates Fixed loan interest-for-floating for negatively GAP bank to reduce
GAP exposure
Using interest rate caps
Managing Credit RiskManaging Credit Risk
Variability of return caused by delayed or nonpayment of loan/security interest or principal
Bank assembles portfolio of various types of loans seeking maximum net return per level of risk
Loan/security mix varies with desired risk level and economic conditions
Measuring Credit RiskMeasuring Credit Risk
Calculate Expected Loss Rate Per Type Of Loan and Total Loan Portfolio
Higher Default Premiums Charged For Higher Expected Loss Rate
Collateral may reduce expected loss rate Prime Plus Loan Pricing based on risk
profile
Diversifying Credit RiskDiversifying Credit Risk
Assemble loan portfolio of diverse Borrowers using portfolio theory: Varied income or employment Geographic locations Industries
Reduce total portfolio credit risk via diversification
Avoid concentration of loans Nationwide banking = diversification
Managing Credit RiskManaging Credit Risk
Diversifying credit risk International diversification of loans
May not help if the bank accepts loans from areas with very high credit risk
LDC’s in early 1980’s; Asian crises, 1997; Argentina, 2001
Selling loans Problem loans can be removed from the bank’s assets Selling price reflects expected default risk
Revising the loan portfolio in response to economic conditions
Managing Market RiskManaging Market Risk
Market risk results from the changes in value of securities due to changes in financial market conditions such as interest rates, exchange rates, and equity prices
Banks have increased exposure to derivatives and trading activities
Measuring market risk: Banks commonly use value-at-risk (VAR), which involves determining the largest possible loss that would occur in the event of an adverse scenario
Managing Market RiskManaging Market Risk
Measuring market risk Bank revisions of market risk measurements
When changes in market conditions occur, such as increasing volatility, banks revise their estimates of market risk
How J.P. Morgan assesses market risk Calculates a 95 percent confidence interval for the
expected maximum one-day loss due to: Interest rates Exchange rates Equity prices Commodity prices Correlations between these variables
Managing Market RiskManaging Market Risk
Methods of reducing market risk Reduce involvement in activities that cause high
exposure Take offsetting trading positions Sell securities that are heavily exposed to market
risk
Operating RiskOperating Risk
Operating risk is the variability of returns that may result from a failure in a bank’s general business operations Processing and sorting information Executing transactions Maintaining relationships with clients Dealing with regulatory issues Legal issues
Use of insurance, contracts, and other pure risk management techniques
Bank Capital ManagementBank Capital Management
Bank capital = bank net worth Purpose of bank capital
Absorbs losses on assets Provides base for leveraging debt Is a source of funds Serves to maintain confidence of financial markets
Regulators specify minimum capital per riskiness of assets
ROE = ROA x leverage measure
Management Based on ForecastsManagement Based on Forecasts
Some banks position themselves to benefit form expected changes in the economy
If managers expect a strong economy they may shift toward riskier loans and securities
Inaccurate forecasts have less effect on more conservative banks
Bank Restructuring to Manage RisksBank Restructuring to Manage Risks
Decisions are complex because they affect customers, employees, and shareholders
Bank acquisitions Common form of restructuring Quick way of achieving growth Advantages:
Economies of scale, diversification Managerial advantages
Disadvantages Purchase price may be too high; selling shareholder benefit Employee morale
Bank Restructuring to Manage RisksBank Restructuring to Manage Risks
Are bank acquisitions worthwhile? Studies show that the market reacts neutrally or
negatively to news of a bank acquisition May be due to:
Intra-market versus out-of-market merger Pessimism over whether efficiencies will be achieved Personnel clashes Price may be too high; selling shareholder capture added value
Integrated Bank ManagementIntegrated Bank Management
Bank management of assets, liabilities, and capital is necessarily integrated
An integrated management approach is also necessary to manage Liquidity risk, Interest rate risk, Credit risk Operating risk Capital or insolvency risk
Examples of Bank MismanagementExamples of Bank Mismanagement
Penn Square Bank Aggressive lending, concentrated in energy loans Limited diversification Energy sector problems caused defaults The bank provided new loans, part of which were
used to pay off old loans, recording them as “paid” rather than overdue
Could not continue this practice, so the bank failed in 1982
Examples of Bank MismanagementExamples of Bank Mismanagement
Continental Illinois Bank Provided loans in the energy sector originated by
Penn Square—financial market lost confidence Bank of New England
Concentrated on real estate loans in 1980s Overbuilding and reduced economic growth
resulted in defaults Even though other New England banks were
affected, the Bank of New England was more exposed because of heavy concentration in real estate
Examples of Bank MismanagementExamples of Bank Mismanagement
Implications of bank mismanagement Preceding examples should not imply that being
ultraconservative is preferred In a competitive environment, a bank may fall
behind A proper balance between risk and return should
be maintained