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Bank Management

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Title: Bank Management


1
Bank Management
  • General Principles

2
Primary Concerns of the Bank Manager
  • Deposit outflows must match deposit inflows.
  • To keep enough cash on hand, the bank manager
    must engage in liquidity management.
  • Risk levels must be acceptably low.
  • To keep risk low, the bank manager must engage in
    asset management by acquiring assets that have a
    low rate of default and by holding a portfolio
    that is well diversified.

3
Primary Concerns of the Bank Manager
  • Funds must be acquired at low cost.
  • To increase profits by acquiring funds at low
    cost, the bank manager engages in liability
    management.
  • Capital must meet regulatory standards.
  • To maintain and acquire capital, the bank manager
    engages in capital adequacy management.

4
Liquidity Management
  • Financial institutions face liquidity management
    problems because the volume of cash flowing in
    rarely matches exactly the volume of cash flowing
    out.
  • In addition, some liabilities are payable
    immediately upon demand, resulting in the outflow
    of cash with little or no notice. And...

5
Liquidity Management
  • Financial institutions are sensitive to interest
    rate movements, which affect the flow of savings
    they attract from the public and the earnings
    from the loans and securities they acquire.

6
Liquidity Management
  • Liquidity managers usually meet their
    institutions cash needs through two methods
  • Asset management or conversion ie., the selling
    of selected assets.
  • Liability management ie., the borrowing of
    enough liquidity to cover a financial
    institutions cash demands as they arise.

7
Sources and Uses of Funds Method
  • To estimate the financial institutions future
    liquidity needs, the bank manager could use the
    sources and uses of funds method.
  • The institutions estimated liquidity deficit or
    surplus equals the estimated change in liquidity
    sources minus the estimated change in liquidity
    uses.

8
Sources and Uses of Funds Method Example
Planning Estimated Change in Estimated Change
in Estimated Interval Funds Sources in Funds
Uses Surplus/ Deficit Tomorrow 25
million 20 million 5 million Next
Day -10 million 10 million -20
million The bank manager could invest the 5
million surplus overnight in order to earn
interest income, and then the next day must
borrow 20 million from some other institution.
9
The Structure of Funds Method
  • To estimate the financial institutions future
    liquidity needs, the bank manager could use the
    structure of funds method.
  • The institutions liabilities are divided into
    categories based on their estimated probability
    of leaving the institution. Funds are then
    allocated to cover those liabilities according to
    the likelihood that they will leave.

10
The Structure of Funds Method Example
  • Some funds received may be hot money that are
    highly sensitive to changes in interest rates.
  • 90 or more of these funds should be covered with
    holdings of liquid assets or borrowings.
  • Other funds are core funds that are highly
    stable.
  • Only 10 of these funds might be covered 10.

11
The Structure of Funds Method Example
Estimated liquidity need 0.90 x (Hot money
funds) 0.10 x (Core funds)
Estimated new loan demand from customers
0.90 x (60 million) 0.10 x (100 million)
36 million 100 million The
liquidity manager would want to make sure that
100 million was available in some combination
of holdings of liquid assets and borrowing
capability.
12
Liquidity Indicators
  • Liquidity indicators supply bank managers with
    signs that a liquidity problem is developing.
    They include
  • Ratio of cash to total assets.
  • Ratio of hot money assets to hot money
    liabilities.
  • Cost of borrowing for liquidity needs relative to
    the cost other institutions face.
  • Monitoring the intentions of the banks biggest
    customers.

13
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 20 Deposits
100 Loans 80 Bank Capital
10 Securities 10
Let the banks reserve requirement be 10 of
deposits or 10. Under these circumstances, an
unexpected deposit outflow of 10 presents no
problems for the bank. Why?
14
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 10 Deposits
90 Loans 80 Bank Capital
10 Securities 10
The bank loses 10 of deposits and 10 of
reserves, but since required reserves are now 10
of 90, it still has 1 in excess reserves. If a
bank has ample reserves, a deposit outflow does
not necessitate changes in other parts of its
balance sheet.
15
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 10 Deposits
100 Loans 90 Bank Capital
10 Securities 10
Let the banks reserve requirement be 10 of
deposits or 10. Under these circumstances, an
unexpected deposit outflow of 10 does present a
problem for the bank. Why?
16
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 0 Deposits
90 Loans 90 Bank Capital
10 Securities 10
After the withdrawal of 10 in deposits, the bank
needs 9 in reserves, but it has none. To
eliminate the shortfall, the bank could sell
assets or borrow
17
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 9 Deposits
90 Loans 90 Borrowings
9 Securities 10 Bank Capital 10
If the bank borrows 9 from other banks or
corporations, the bank incurs the cost associated
with the borrowing.
18
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 9 Deposits
90 Loans 90 Securities 1 Bank
Capital 10
If the bank sells securities, the bank incurs the
costs associated with the sale. These costs
include brokerage and other transactions costs as
well as the loss of future income.
19
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 9 Deposits
90 Loans 90 Discount Loan
9 Securities 10 Bank Capital 10
If the bank borrows from the Federal Reserve, it
also incurs costs. The bank must pay the discount
rate charged on Fed loans, and the bank risks
losing its privilege of borrowing from the Fed,
if it borrows too often.
20
Liquidity Management and the Role of Reserves
Assets Liabilities
Reserves 9 Deposits
90 Loans 81 Securities 10 Bank
Capital 10
If the bank calls or sells some loans, the bank
incurs the costs associated with the reduction
of loans. This is the costliest way of
acquiring reserves.
21
Liquidity Management Conclusion
  • Excess reserves are insurance against the costs
    associated with deposit outflows.
  • The higher the costs associated with deposit
    outflows, the more excess reserves banks will
    want to hold.

22
Bank Management II
  • General Principles

23
Asset Management
  • To maximize profits, a bank must simultaneously
    seek the highest returns possible on loans and
    securities, reduce risk, and make adequate
    provisions for liquidity by holding liquid assets.

24
Asset Management
  • Four basic methods of asset management
  • Find borrowers who will pay high interest rates
    and are unlikely to default.
  • Purchase securities with high returns and low
    risk.
  • Lower risk by diversifying.
  • Manage the liquidity of its assets so that it can
    satisfy its reserve requirements without
    incurring large costs.

25
Liability Management
  • Today, banks regularly engage in liability
    management.
  • When a bank finds an attractive loan opportunity,
    it can acquire funds by selling negotiable CDs.
  • If it has a reserve shortfall, it can borrow from
    other banks in the federal funds markets.

26
Raising Funds for a Financial Institution
  • Factors to be considered
  • The relative cost of raising funds from each
    source.
  • The risk (volatility or dependability) of each
    funds source.
  • The length of time (maturity) for which a source
    of funds will be needed.
  • The size and market access of the financial
    institution attempting to raise funds.
  • Laws and regulations that limit access to funds.

27
Relative Cost Factor
  • The relative cost factor is important because,
    other things remaining the same, a financial
    institution would prefer to borrow from the
    cheapest sources of funds available.
  • Also, if an institution is to maintain consistent
    profitability, its cost of fund raising must be
    kept below the returns earned on the sales of its
    services.

28
Pooled-Funds Approach Example
Sources of New Funds Volume of New Interest
Costs Other Funds Generated Expenses
Incurred Deposits 200 20 Money
Market Borrowing 50
5 Equity Capital 50 5 Total
New Funds 300 30 Estimated
overall cost of funds for the institution
is Pooled All Expected Fund
Raising Fund Raising Costs 30
10 Expense Total New
Funds 300
29
Pooled-Funds Approach Example
If only 250 of the 300 in funds raised can
be used to invest in new loans and
investments, the estimated overall cost of funds
changes. Estimated overall cost of funds for
the institution is Pooled All
Expected Fund Raising Fund Raising
Costs 30 12
Expense Total New Funds 250
Now the bank must earn at least 12 on its loans
and other earning assets just to cover its
fund-raising costs. When it could use all the
funds raised for loans and other investments,
it only needed to earn 10 to cover the
fund-raising costs.
30
Capital Adequacy
  • Functions of bank capital
  • Help to prevent bank failure
  • Affects returns for equity holders
  • Required by regulatory authorities

31
Capital and Bank Failure
High Capital Bank
Low Capital Bank
Assets Liabilities Assets Liabilities
Reserves 10 Deposits 90 Reserves
10 Deposits 96 Loans 90 Bank K
10 Loans 90 Bank K 4
Assume that both banks write off 5 of their loan
portfolio. Total assets decline by 5, and bank
capital, which equals assets minus liabilities,
also declines by 5.
32
Capital and Bank Failure
High Capital Bank
Low Capital Bank
Assets Liabilities Assets Liabilities
Reserves 10 Deposits 90 Reserves
10 Deposits 96 Loans 85 Bank K
5 Loans 85 Bank K - 1
After the write-off, the high capital bank still
has a positive net worth, but the low capital
bank is insolvent. It does not have sufficient
assets to pay off its creditors. Regulators will
now close the bank and sell its assets. A bank
maintains bank capital to lessen the chance that
it will become insolvent.
33
Bank Capital and Returns to Owners
A basic measure of bank profitability is return
on assets ROA ROA Net profit after
taxes/assets. This measure provides information
on how efficiently a bank is being run because
it indicates how much profit is generated on
average by each dollar of assets.
34
Bank Capital and Returns to Owners
Another measure of bank profitability is return
on equity ROE ROE Net profit after
taxes/Equity capital. This measure provides
information on how much the bank is earning on
the investors equity investment.
35
Bank Capital and Returns to Owners
There is a direct relationship between the return
on assets and the return on equity. This
relationship is determined by the
equity- multiplier (EM). EM is the amount of
assets per dollar of equity capital. EM
Assets/equity capital Net profit after taxes
Net profit after taxes x Assets
Equity capital Assets
equity capital
ROE ROA x EM

36
Bank Capital and Returns to Owners
We can use the ROE formula to examine what
happens to the return on equity when a bank holds
a smaller amount of assets per dollar of
capital. Let each bank receive a return on
assets equal 1. ROE ROA x
EM High Capital Bank ROE 1 x 100/10
10 Low Capital Bank ROE 1
x 100/4 25 Given the return on assets,
the lower the bank capital, the higher the return
for the owners of the bank.
37
Trade-off between Safety and Return
  • Bank capital reduces the likelihood of
    bankruptcy, but it is costly because as bank
    capital rises, return on equity falls.
  • Bank managers must determine how much safety they
    are willing to trade off against the lower return
    on equity.
  • The more uncertain the times, the larger the
    amount of capital held.

38
Bank Capital and Returns to Owners
Another commonly watched measure of bank
performance is called the net interest margin
(NIM), the difference between interest income and
interest expenses as a percentage of total
assets. NIM interest income -
interest expenses assets
If a bank manager has done a good job, the bank
will have high profits and low costs. This is
reflected in the spread between interest earned
and interest costs.
39
Bank Capital Requirements
  • Basle Agreement
  • An agreement among the central banks of leading
    industrialized nations, including the nations of
    Western Europe, the United States, and Japan, to
    impose common capital requirements on all their
    banks in order to control bank risk exposure and
    avoid giving one nations banks an unfair
    advantage over another nations banks. It
    provides minimum capital standards.

40
Basle Agreement
  • The Basle Agreement (1998) stipulates that banks
    in all participating nations must have a minimum
    ratio of total capital to risk-weighted assets
    and other related risk-exposed items of 8
    percent.
  • Risk weighted assets are determined by
    classifying each of the banks assets listed on
    its balance sheet into categories based on risk
    exposure and then multiplying each category by a
    fractional risk weight ranging from 0 for cash
    and government securities to 1 for commercial
    loans and other high risk assets.

41
Basle Agreement Example
0 x (Cash and U.S. government securities) 0.2
x (Other types of government securities and
interbank deposits) 0.5 x (Residential mortgage
loans, government revenue bonds and selected
types of mortgage backed securities) 1 x
(Commercial and consumer loans and other assets
of the highest risk exposure).
Total risk-weighted assets on a banks balance
sheet

42
Basle Agreement
  • The Basle Agreement was unique in also including
    off-balance sheet commitments that banks make to
    their largest customers, as well as commitments
    banks make to hedge themselves against risk.
  • The amount of each off-balance sheet item is
    multiplied by a fractional amount know as its
    credit-equivalent value, which is, in turn,
    multiplied by a fractional risk weight based on
    its assumed degree of risk exposure.

43
Basle Agreement Example
Total risk-weighted assets on and off a banks
balance sheet
Total risk-weighted assets on a banks balance
sheet
Total risk-weighted off-balance sheet items

x
44
Basle Agreement
  • To determine a banks total capital, its
    longer-maturity liabilities and its equity are
    classified into two broad categories
  • Tier-one or permanent core bank capital which
    includes
  • Tangible equity including common stock
    perpetual preferred stock retained earnings
    capital reserves less intangibles.
  • Tier-two or supplemental capital which includes
  • Subordinated capital notes and debentures over 5
    years to maturity limited-life preferred stock
    loan loss reserves.

45
Basle Agreement
  • The Basle Agreement requires each bank in all
    participating countries to achieve and hold the
    following capital minimums
  • Tier-one capital divided by total risk-weighted
    on and off balance sheet items must equal at
    least 4.
  • Total tier-one plus tier two capital divided by
    total risk-weighted on and off balance sheet
    items must equal no less than 8.
  • A bank with a 4 tier-one capital ratio and a 5
    tier-two capital ratio would have a ratio of
    total capital to risk-weighted on and off balance
    sheet items of 9.

46
Basle Agreement
  • In the U.S. and selected other countries, a bank
    that holds more than the required minimum amounts
    of capital is allowed to expand its services and
    service facilities with few or no regulatory
    restrictions imposed.
  • But, if bank capital drops below the minimum
    percentage, regulatory restrictions become
    increasingly stiff.

47
Off Balance-Sheet Activities
  • Loan sales or secondary loan participation
  • A contract that sells all or part of the cash
    stream from a specific loan and thereby removes
    the loan from the banks balance sheet.
  • Banks earn profits by selling loans for an amount
    slightly greater than the amount of the original
    loan.
  • Institutions are willing to buy them at the high
    price because of the high interest rates
    associated with the loans.

48
Off Balance-Sheet Activities
  • Generation of Fee Income
  • Banks charge fees for specialized services such
    as
  • Making foreign exchange trades
  • Servicing a mortgage-backed security by
    collecting interest and principal payments and
    then paying them out, and providing lines of
    credit.
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