Dr. David P Echevarria All Rights Reserved 1 BANK MANAGEMENT BANK PERFORMANCE CHAPTERS 19, 20.

Dr. David P Echevarria All Rights Reserved 1

BANK MANAGEMENTBANK PERFORMANCE

CHAPTERS 19, 20


BANK PERFORMANCE EVALUATION

A. Bank Profits1. P = Loans x Realized Loan Yield minus Deposits

x Cost per $ of Deposits - Fixed Expenses2. RLY = Contractual rate x Good Loan Fraction -

(1-Recov. rate) x Bad Loan Fraction3. Cost of Deposits = Interest paid plus the cost of

free services4. Fixed Costs = the cost of everything else the

bank needs to run the business



B. Realized Loan Yield Example1. RLY = Contractual rate x Good Loan Fraction - (1-

Recov. rate) x Bad Loan Fraction

2. Consider an average rate of 12%, 90% good loans and a recovery rate of 85% on bad loans. The RLY in this example is 9.3%

3. RLY = .12 x .9 - (1-.85) x .10 = .093 or 9.3%

4. If the bank has a $100,000,000 portfolio, that equates to $9,300,000 in interest income after writing off $1,500,000 in bad loan losses (against $10,800,000 interest income)



C. Return on Equity: ROE = Profits / Equity

D. Methods of Increasing ROE1. Lower Equity (increase leverage); a risky move

in a volatile environment – especially during periods of low profitability

2. Equity Ratio = equity / loans and investments



3. Raise Profits by increasing revenue:a. Increase contractual rates

b. Lend more money; need to increase deposits,

c. Decrease free services or start charging for them

d. Lower variable costs

e. Lower fixed costs; problem of indivisibility

f. Tighten loan standards; could result in lowering total loan portfolio

g. Offer other low-cost high margin services; i.e., brokerage, insurance, etc

h. Increasing size to get benefits of scale

i. Securitizing collateralized loans; retaining servicing fee income



E. Market Considerations1. Competition limits ability to raise loan rates,

reduce services, or reduce deposit ratesa. Increasing loan rates and decreasing deposit rates

increases the Net Interest Marginb. Ability to make loans a function of;

(1) excess reserves or (2) required reserve ratio

2. Customers know more than the banka. Problem of asymmetric informationb. Adverse selection; raise rates and best quality

customers may leave



F. The Risk-Return Tradeoff1. Competition and adverse selection limit ability to increase earnings

from lending2. Other investments offer higher returns but carry interest rate risk;

a. Rather than lending, could invest depositors cash in interest earning securities

b. As interest rates change, value of the investment portfolio changesc. What happens when value of the assets are less that value of liabilities?

G. A Final Pass on Deposits, Reserves, and Liquidity1. Increasing deposits also increases variable costs2. Ability to make loans a function of excess reserves (cash in vault:

opportunity cost)3. Liquidity is necessary to service client demand for cash


WHY BANKS FAIL

A. The Most Frequently Given Reasons for Bank Failure

1. Bank officer fraud2. Excessive Bad Loans3. Inadequate Liquidity / Inadequate Capital4. Deregulation and Resultant Increase in

Competition5. Regulatory forbearance6. Non preparedness for increase in interest rate

risk


RECENT DEVELOPMENTS IN BANK MANAGEMENT

B. Bank Response to New Capital Requirements1. Issuance of new stock2. Merger with a stronger bank3. Shrinking the Balance Sheet.; reduction in assets, w/o

changes in equity, increases equity ratio or pushing for acquisition by larger bank

4. Increase ratio of Risk-Sensitive Assets to Risk Sensitive Liabilities


SOURES OF RISK IN BANK PORTFOLIOS

A. Examining the Proportion of Rate Sensitive Assets and Liabilities

1. GAP Analysis → Changes in Incomea. GAP = Rate Sensitive Assets (RSA) – Rate Sensitive Liabilities (RSL)b. DI = GAP * Di

2. Rate Sensitive Assets:c. Short-Term Loans (Maturities 1 year or less); commercial or consumerd. Variable Rate Mortgagese. The proportion of fixed rate mortgages that are repaid earlyf. The proportion of auto loans paid early

3. Rate Sensitive Liabilitiesa. Money Market Depositsb. Variable Rate CDs and CDs maturing in 1 year or lessc. Borrowings with maturities 1 year or less


RISK IN BANK PORTFOLIOS

B. Interest Rate Changes and GAP1. If a financial institution has more rate sensitive

liabilities (RSL) than rate sensitive assets (RSA), then the GAP will be negative:

a. GAP = RSA – RSL

b. If RSL > RSA, then GAP < 0 (negative)

2. Any increases in Interest rates will reduce the GAP (or net interest rate margin) and result in net income decline:


RISK IN BANK PORTFOLIOS

C. Bank Profits a function of interest rate expectations1. If interest rates expected to go up, then allocate assets to

short-term loans → rollover at higher rates

2. If interest rates expected to go down, allocate assets to long-term loans → less rollover

D. Forecasting interest rates is important1. Effects on GAP of Proportions of RSA and RSL

2. Magnitude of excess reserves is key to loss containment strategy


MANAGING INTEREST RATE RISK (Gap)

A. Potential Strategies1. Maturity matching; would drive Commercial banks to

short-term loans2. Floating-rate loans; unpopular with borrowers3. Financial Futures; high leverage, high risk (basis risk)4. Interest Rate Swaps; potentially risky if wrong on

expectations or arrangements B. The Scenarios for Interest rate Swaps

1. Long-Run increase in interest rates; decreases the gap2. Long-Run decrease in interest rates; increases the gap


MANAGING INTEREST RATE RISK (The Gap)

C. Types of SWAPS:1. Fixed rate for Floating Rate Swap: rates calculated at

time of swap2. Forward Swap; setting the rates now for future swap3. Swaptions: hybrid arrangements for early termination

a. Callable Swap: party making fixed payments option to terminate before maturity [Desirable if interest rates decline]

b. Putable Swap: party making floating payments option to terminate before maturity [Desirable if interest rates increase]



A. Banking Regulation Seeks to Reduce Financial Shocks

1. Banks must have higher levels of capital; BIS (Bank for International Settlements)

a. Tier 1: Book Value of Stock plus retained earningsb. Tier 2: Sum of Loan-Loss reserves and subordinated debtc. Total capital = Tier 1 plus Tier 2

2. How much a bank must have in each category a function of risk-adjusted assets

a. Risk-Weighted Capital Requirements and Asset Types;b. Cash and Government Securities = 0 risk weightc. Loans = 1.0 risk weightd. Mortgages = 0.5 weighte. Inter bank deposits = 0.2 weight



3. The [Separate] Leverage Requirementa. Tier 1 capital; 3% of all unweighted assets

b. If risky, may require 4-6%

4. Off-Balance Sheet assets not counted


HOMEWORK QUESTIONS A. How are depository institutions' profits determined?B. How does the bank realized loan yield (RLY) affected by credit

policies?C. If a bank has low ROE (or ROA), what strategies might it pursue?D. What determines the ability of a bank to expand loan activity?E. What is meant by Adverse Selection? How does it affect bank

operations?F. How have banks responded to the capital requirements under the BIS

standard?G. What is the single largest source of risk for banks?H. What are Swaps and how do banks use them?I. What are the special considerations involved in structuring Swap deals?J. What are the ways banks can increase their profits?K. What are the two biggest dangers they face in doing so?L. Why are banks trying to get larger and to expand their activities?

Dr. David P Echevarria All Rights Reserved 1 BANK MANAGEMENT BANK PERFORMANCE CHAPTERS 19, 20.

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Transcript of Dr. David P Echevarria All Rights Reserved 1 BANK MANAGEMENT BANK PERFORMANCE CHAPTERS 19, 20.