Chapter 14

CHAPTER 14BANK MANAGEMENTAND PROFITABILITY

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Bank Earnings

Interest and fees on loans is traditionally the major source of income for commercial banks.Interest paid on deposits is one of the largest expense items. Both of the above follow market rates of interest.Net interest income represents the difference between gross interest income and gross interest expense.

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Bank Earnings

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Bank Earnings - continued

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Interest Income and Expense (1935-2001)

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Bank Earnings (continued)

The provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account).Banks increase their provision for loan losses in anticipation of credit quality problems in their loan portfolio.Loans are written off against the loan loss reserve

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Provision for Loan Losses (1935-2001)

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Bank Earnings (concluded)

Noninterest income includes fees and service charges. This source of revenue has grown significantly in importance.Noninterest expense includes salary expenditures. These expenses have also grown in recent years. Because of lower interest rates, Wachovia reported for 2004 that Salaries and Employee Benefits alone were $8.7 billion, while total interest expense was $5.3 billion.

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Noninterest Income and Expense (1935-2001)

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Bank Performance

Trends in profitability can be assessed by examining return on average assets(net income / average total assets) over time. (Wachovia in 2004 was 1.22%)Another measure of profitability is return on average equity. (Wachovia in 2004 was 14.77%)Other measures that are widely used are Risk Adjusted Return on Capital (RAROC) and Economic Profit (Economic Value Added).In the mid- and late-1990s, bank profitability improved significantly.

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ROAA and ROAE (1935-2001)

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Banking Dilemma: Profitability Versus Safety

One way for a bank to increase expected profits is to take on more risk. However, this can jeopardize bank safety.For a bank to survive, it must balance the demands of three constituencies:shareholders, depositors, and regulators, each with their own interest in profitability and safety.The bank has to be concerned with shareholder wealth maximization.

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(continued)

Bank Solvency -- Maintaining the momentum of a going concern, attracting customers and financing in the market.

A firm is insolvent when the value of its liabilities exceeds the value of its assets.Banks have relatively low capital/asset positions and high quality assets.

Bank Liquidity -- the ability to accommodate deposit withdrawals, loan requests, and pay off other liabilities as they come due.

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(concluded)Banks supply liquidity to customers.

Depositors store their liquidity in banks; loan customers come to the bank to borrow liquidity.The bank supplies liquidity from two sources: sale of assets and borrowing.

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The Dilemma

A bank must successfully balance profitability on one hand and liquidity and solvency on the other.Bank failure can result from the depletion of capital caused by losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable.Failure can also occur if a bank cannot meet the liquidity demands of its depositors -- a run on the bank occurs. If assets are profitable, but illiquid, the bank also has a problem.Bank insolvency very often leads to bank illiquidity.

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Profitability Goal VersusLiquidity and Solvency

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Liquidity Management

Banks rely on both asset sources of liquidity and liability sources of liquidity to meet the demands for liquidity.The demands for liquidity include accommodating deposit withdrawals, paying other liabilities as they come due, and accommodating loan requests.

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Asset Management (classifies bank assets from very liquid/low profitability

to very illiquid/profitable).

Primary Reserves are non-interest bearing, extremely liquid bank assets.

Vault cashDeposits at correspondent banksDeposits at the Federal Reserve Banks

Secondary Reserves are high-quality, short-term, marketable earning assets.

Treasury billsShort-term agency securities that can be converted quickly

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Asset Management (continued)

Bank Loans are made after absolute liquidity needs are met.

Typically the highest yieldGenerally the most risky

Investments. After loan demand is satisfied, funds are allocated to Income Investments that provide income, reasonable safety, and some liquidity, if needed.

Open marketMay provide tax advantages

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Asset Management (concluded)

The bank must manage its assets to provide a compromise of liquidity and profitability.The primary and secondary reserve level is related to:

reserve requirementsdeposit variability.other sources of liquidity.bank regulations - permissible areas of investment.risk posture that bank management will assume.

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Summary of Asset Management Strategy

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Liability Management (LM)

Assumes that the bank can borrow its liquidity needs in financial markets.Liability levels (borrowing) may be adjusted to loan (asset) needs or deposit variability.LM assumes that the bank may raise sufficient amounts of funds by paying the market rate.Bank liability liquidity sources include the bank's "borrowing" liability category.The liquidity gained by liability management is useful because it can be used to counteract deposit inflows and outflows.

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Liability Management (LM) -continued

Also, funds attracted by liability management may be used to meet increases in loan demand by the bank’s customers.Bank liabilities employed in liability management are:

Negotiable Certificates of DepositFederal FundsRepurchase AgreementsCommercial PaperEurodollar borrowings

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Liability Management (LM) - concluded

LM supplements asset management, but does not replace it. Asset management is still the primary source of liquidity for banks, especially smaller banks.

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Functions of the Bank Capital

Absorb losses on assets (loans) and limit the risk of insolvency.Maintain confidence in the banking system.Provide protection to uninsured depositors and creditors.Act as a source of funds and serve as a leverage base to raise depositor funds.

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Trends in Bank CapitalCapital levels declined in the late 1960s and early 1970s as banks’ assets grew faster than their capital levels.The number of bank failures increased significantly in the 1980s and early 1990’s.The Basel Accord of 1988 set capital adequacy standards for international banks.Capital standards were increased in the early 1990’s in response to these failures.By the early 2000’s, bank capital ratios had increased substantially.In June 2004 the Basel Committee on Bank Supervision published new international guidelines for determining regulatory capital.

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Bank Capital Ratios (1934-2001)

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A Definition of Bank Capital

As bank capital requirements were increased, regulators also implemented risk-based capital standards. Capital levels are measured against risk-weighted assets. Risk-weighted assets is a measure of total assets that weighs high-risk assets more heavily than low-risk assets.The purpose is to require high-risk banks to hold more capital than low-risk banks.

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A Definition of Bank Capital (continued)

The current standards define two forms of capital:

Tier 1 capital includes common stock, common surplus, retained earnings, noncumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets.Tier 2 capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures.

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A Definition of Bank Capital (concluded)

The minimum capital requirements:the ratio of Tier 1 capital to risk-weighted assets must be at least 4 percent, andthe ratio of Total Capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8 percent.

Capital levels are also used by regulators to determine the level of regulatory scrutiny a bank should receive and whether a bank should have any limits placed on its activities.Wachovia had a 7.86% Tier 1 capital ratio and a 11.52% Total capital ratio in 2004.

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Risk Weights Used in Calculating Risk-Weighted Assets

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Risk Weights Used in Calculating Risk-Weighted Assets (concluded)

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Capital Guidelines forRegulatory Action

CAPITAL CATEGORIES

TOTAL RISK-BASED CAPITAL RATIO

TIER 1 RISK-BASED CAPITAL RATIO

LEVERAGE RATIO

Well capitalized 10 percent or greater

AND 10 percent or greater


Adequately capitalized

8 percent or greater



Undercapitalized Less than 8 percent

OR Less than 4 percent


Significantly undercapitalized

Less than 6 percent



Critically undercapitalized

-- -- --

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Managing Credit Risk

The credit risk of an individual loan concerns the losses the bank will experience if the borrower does not repay the loan.The credit risk of a bank’s loan portfolio concerns the aggregate credit risk of all the loans in the bank’s portfolio. Banks must manage both dimensions effectively to be successful.

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Managing the Credit Risk of Individual Loans

Begins with the lending decisions (and the 6 Cs as discussed in Chapter 13).Requires close monitoring to identify problem loans quickly.The goal is to recover as much as possible once a problem loan is identified.

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Managing the Credit Risk of Loan Portfolios

Internal Credit Risk Ratings assigned to individual loans are used to

identify problem loans,determine the adequacy of loan loss reserves, andloan pricing and profitability analysis.

Loan Portfolio Analysis is used to ensure that banks are well diversified.

Concentration ratios measure the percentage of loans allocated to a given geographic location, loan type, or business type.

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Managing Interest Rate Risk

Gross interest income and gross interest expense have become more volatile in the last 30 years. Consequently, interest rate risk has become a concern to both bank managers and bank regulators.

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Net Cash Flow from Funding a $1,000 Loan with a 3-Month CD and a 6-Month CD (Assuming No Change in Interest

Rates)

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Net Cash Flow from Funding a $1,000 Loan with a 3-Month CD and a 6-Month CD (Assuming a 1 Percent Increase in

Interest Rates)

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Measuring Interest Rate Risk: Maturity GAP Analysis

Assets and liabilities which can be repriced (change the earnings/expense rate in a specified period of time) are identified as rate sensitive.A bank's GAP for a period of time is computed by subtracting rate sensitive liabilities (RSL) from rate sensitive assets (RSA).The GAP can be expressed as dollars or as a percentage of total earning assets.

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GAP = RSA - RSL

Controlling the size of the GAP is an important management decision

Risk AcceptanceForecast of future interest rates

Positive GAP = RSA > RSLNet interest income will decline if interest rates fall in the GAP period.More assets than liabilities will be repriced downward if interest rates decline, thus reducing net interest income.What happens if interest rates increase?

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GAP = RSA - RSL (concluded)

Negative GAP = RSA < RSLNet interest income will decline if interest rates increase in the GAP period.More liabilities than assets will be repriced upward if interest rates increase, thus reducing net interest income.

The greater the GAP, either positive or negative, the greater the bank’s exposure to interest rate risk

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GAP Management

The tendency is for banks that are expecting higher interest rates to accept large positive GAPs and to plan to decrease the GAPs as interest rates turn down.However, because the demand for short-term loans is usually heaviest when interest rates are high, most banks can’t close the gap when they want to.To overcome this problem, bank fund managers are turning to financial futures to hedge exposed asset and liability risk positions.

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Managing Interest Rate Risk: Duration GAP Analysis

Simple maturity matching, discussed before, may not produce the same cash flow or repricing timing in any period.Duration GAP analysis matches cash flows and their repricing capabilities over a period of time.A one-year fixed-rate loan, interest paid monthly, has a different cash flow pattern (shorter duration) than the one-year CD, interest paid at maturity. The percentage change in the value of a portfolio, given a change in interest rates, is proportional to the duration of the portfolio multiplied by the change in interest rates.

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Managing Interest Rate Risk: Duration GAP Analysis

(concluded)

DG = duration gap

DA = duration of assets

DL = duration of liabilities

MVA = market value of assets

MVL = market value of liabilities

Duration GAPs are opposite in sign from maturity GAPs for the same risk exposure.www.Bankrate.com

LALAG DMVMVDD )/(

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Value at Risk (VAR)

The Value at Risk methodology uses recent market volatility to estimate within a given level of confidence the maximum trading loss that would be expected for the bank to incur from an adverse movement in market rates and prices over the period. VAR evaluates overall riskiness for banks. VAR measure the loss potential up to a certain probability within a given time period.

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Value at Risk - continued

V = - D

r ( 1 + r)

X P

V / r = the sensitivity of changes in asset values to changes in the risk factor

D = Duration

P = Probability Desired using a Normal Distribution

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Value at Risk (VAR) Methodology at Wachovia

The 2004 Annual Report of Wachovia reported (page 42) that the bank used the most recent 252 trading days to estimated within a given level the maximum trading loss over a period of time.The 1-day VAR limit in 2004 was $30 million. The total 1-day VAR was $21 million at December 31, 2004.

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Hedging Interest Rate Risk

Matched hedging is a form of microhedging, which is hedging a specific transaction.Macrohedging, on the other hand, involves using instruments of risk management, such as financial futures, options on financial futures, and interest rate swaps to reduce the interest rate risk of the bank’s entire balance sheet.

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Techniques For Hedging Interest Rate Risk

Adjustments by asset-sensitive institutions with positive maturity GAP, negative duration GAP--hurt by decreasing interest rates

Buy financial futures--falling rates would increase value of futures contract, offsetting negative impact of GAP situationBuy call options on financial futuresSwap to increase their variable-rate cash outflows and increase their fixed-rate (long-term) cash flowsLengthen the repricing of assets; shorten the repricing capability of liabilities

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Techniques For Hedging Interest Rate Risk (concluded)

Adjustments by liability-sensitive institutions with negative maturity GAPs or positive duration GAPs--hurt by increasing interest rates

Sell financial futures--increasing rates would increase value of futures contracts, offsetting the negative impact of GAP situationBuy put options on financial futuresSwap long-term, fixed-rate payments for variable-rate paymentsShorten the repricing of assets; lengthen the repricing capability of liabilities

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Interest Rate Swaps

Interest rate swaps are privately negotiated agreements than can be tailor made to fit the circumstances of particular counterparties.Swaps can be made for more varied maturities than is possible with futures, tailored to particular interest rates, and the settlement dates can be designed to fit the cash flow pattern of the counterparties.Swaps are less marketable and carry more default risk than financial futures.

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Conclusion

Bank profitability vs. solvency and liquidityAsset ManagementLiability ManagementBank CapitalMaturity GAP AnalysisDuration GAP AnalysisValue at RiskHedging Interest Rate Risk

Chapter 14

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