Post on 30-Dec-2015
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
Copyright © 2014 Pearson Canada Inc. 13-2
Learning Objectives
1. Outline a bank’s sources and uses of funds2. Specify Bank Operation: making profits by accepting
deposits and making loans3. 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
Copyright © 2014 Pearson Canada Inc. 13-3
Assets
• Reserves• Cash Items in Process of Collection• Deposits at Other Banks• Securities• Loans• Other Assets
Copyright © 2014 Pearson Canada Inc. 13-4
Liabilities
• Demand and Notice Deposits• Fixed-Term Deposits• Borrowings
– overdraft loans (advances)– settlement balances
• Bank Capital
Copyright © 2014 Pearson Canada Inc. 13-5
Balance Sheet of All Banks in Canada
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 Bank Business
Assets Liabilities Assets Liabilities
Loans +$100 Chequable deposits
+$100 Chequable Deposits
+$100 Bank Loans +$100
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
Assets Liabilities
Cash items in process of collection
+$100 Chequabledeposits
+$100
First Bank Second Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Chequable deposits
+$100 Reserves -$100 Chequable deposits
-$100
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 First Bank
Assets Liabilities Assets Liabilities
Desired reserves
+$100 Chequable deposits
+$100 Desired reserves
+$10 Chequable deposits
+$100
Excess reserves
+$90 Loans +$90
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
Copyright © 2014 Pearson Canada Inc. 13-10
Liquidity Management: Ample Reserves
First Bank First Bank
Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank Capital
$10M Loans $80M Bank Capital $10M
Securities $10M Securities $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
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 First Bank
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank Capital
$10M Loans $90M Bank Capital
$10M
Securities $10M Securities $10M
with deposit outflow of $10 million
↓
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
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
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
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $0M
Securities $1M Bank Capital $10M
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
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Advances Bank of Canada
$9M
Securities $1M Bank Capital $10M
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
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Advances Bank of Canada
$0M
Securities $10M Bank Capital $10M
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
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
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
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
Copyright © 2014 Pearson Canada Inc. 13-20
Capital Adequacy Management: Preventing Bank Failure
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
Copyright © 2014 Pearson Canada Inc. 13-21
Capital Adequacy Management: Returns to Equity Holders
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
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 assetsRaising Bank Capital:• Issue more common stock• Reducing dividend to shareholders• Issue fewer loans or sell securities and use proceeds
to reduce liabilities
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
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
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
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
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
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
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
Copyright © 2014 Pearson Canada Inc. 13-31
Managing Interest-Rate Risk
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
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 liabilitiesGAP = RSL – RSA
• A change in the interest rate (Δi) will change bank income (depending on the Gap
Income = GAP i
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
Copyright © 2014 Pearson Canada Inc. 13-34
Duration Analysis (cont’d)
%ΔP = - DUR x [Δi/(1+i)]
Where: P is the market value
%ΔP = (Pt+1 – Pt)/P
DUR = duration
i = interest rate
Copyright © 2014 Pearson Canada Inc. 13-35
Duration Analysis (cont’d)
The Duration Gap can be calculated as:
DURgap = Dura – (L/A x DURL)
Where: Dura = average duration of assets
L = market value of liabilities
A = market value of assets
Durl = average duration of liabilities
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
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
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