bank management - snapshot
TRANSCRIPT
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Bank Management Snap Shot
Chapter Objectives Explain what a balance sheet and a T-
account are.
Explain what banks do in five words
and also at length.
Describe how bankers manage their
banks balance sheets.
Explain why regulators mandate
minimum reserve and capital ratios.
Describe how bankers manage creditrisk.
Describe how bankers manage
interest-rate risk.
Describe off-balance sheet activities
and explain their importance.
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1. The Balance Sheet
Chapter Objectives
Explain what a balance sheet and a T-account are.
What is a balance sheet and what are the major typesof bank assets and liabilities?
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1. The Balance Sheet
ASSETS = LIABILITIES + EQUITY
Uses of Funds =
Assets =
Resources =
Resources =
Sources of Funds
Debt Financing + Equity Financing
Borrowings + Ownership stakes
Lenders claims + Owners claims
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1. The Balance Sheet
For banks
ASSETS = LIABILITIES + EQUITY
Assets:Reserves
Secondary reserves
Loans made to customersOther
Liabilities:Deposits owed to customers
Borrowings owed to debt financers
Equity:
Shareholders equity
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1. The Balance Sheet
Key Takeaways
A balance sheet is a financial statement that lists what a company owns,
its assets or uses of funds, and what it owes, its liabilities or sources of
funds.
Major bank assets include reserves, secondary reserves, loans, and other
assets.
Major bank liabilities include deposits, borrowings, and shareholder
equity.
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2. Assets, Liabilities.
Chapter Objectives
Explain what banks do in five words and also at length.
In five words, what do banks do? Without a word
limitation, how would you describe what functions
they fulfill?
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2. Assets, Liabilities.
For banks
ASSETS
Reserves: cash and deposits at the FedRequired reserves + excess reserves = total reserves
Secondary reserves: Government and liquidsecurities
Loans: commercial, consumer, to other banks viaFed Funds or check clearing
Collateralized: mortgage, auto, call loan, etc.
Other property, equipment, etc.
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2. Assets, Liabilities.
For banks
LIABILITIES
Liabilities:Deposits
Transaction deposits: checking,
Non-transaction deposits: savings, Short term, Fixed etc
Time deposits: CDs
Borrowings
from banks via Fed Funds,
from Federal Reserve via discount window
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2. Assets, Liabilities.
For banks
EQUITY
Equity:Shareholders equity
Common stock
Preferred stock
Retained earnings
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2. Assets, Liabilities.
For banks
ASSETS = LIABILITIES + EQUITY
Assets:
Reserves: cash and deposits at the Fed
Required reserves + excess reserves =
total reserves
Secondary reserves Government and
liquid securities
Loans: commercial, consumer, to other
banks via Fed Funds or check
clearing
Collateralized: mortgage, auto, call
loan
Other property, equipment, etc
Liabilities:
Deposits
Transaction deposits: checking,
Non-transaction deposits: savings,Time deposits: CDs
Borrowings
from banks via Fed Funds,
from Federal Reserve via discount
window
Equity:
Shareholders equity
Common stock
Preferred stock
Retained earnings
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2. Assets, Liabilities.
Asset transformation: Banks
Short-termdeposits/ Long-term deposits
Investors
Borrow short
Lend long
Intermediaries
Long-termloans
Entrepreneurs
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2. Assets, Liabilities.
Asset transformation: Finance Companies
Buy bondsor finance
Savers/Investors
Borrow long
Lend short
Intermediaries
Short-termloans
Spenders/Entrepreneurs
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2. Assets, Liabilities.
Asset transformation: Insurance
Prepayexpense
Savers/Investors
Intermediaries
Contingentliabilities
Spenders/Entrepreneurs
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2. Assets, Liabilities.
Key takeaways Banks: lend (1) long (2) and (3) borrow (4) short (5).
Like other financial intermediaries, banks are in the business of
transforming assets, of issuing liabilities with one set of characteristics to
investors and of buying the liabilities of borrowers with another set of
characteristics.
Generally, banks issue short-term liabilities but buy long-term assets.
This raises specific types of management problems bankers must be
proficient at solving if they are to succeed.
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3. Bank Management Principles
Chapter Objectives
Describe how bankers manage their banks balance sheets.
Explain why regulators mandate minimum reserve and capital ratios.
What are the major problems facing bank managers
and why is bank management closely regulated?
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3. Bank Management Principles
Bankers must manage their assets and liabilities to ensure
Liquidity
Profit
Profit
Financing
Liquidity management
Asset management
Liability management
Capital adequacy
management
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3. Bank Management Principles
Liquidity management
Have enoughreserved to satisfy
deposit outflows
Use efficientlyenough to earn
profit
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3. Bank Management Principles
Asset and Liability management
Profit
Investments
Financing
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3. Bank Management Principles
Capital adequacy management
Have enough toprotect against
bankruptcy orregulation
Use efficientlyenough to earn
profit
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3. Bank Management Principles
Bank management risks
Profit
Default
Capitaladequacy
Interestrate
Liquidity
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3. Bank Management Principles
Liquidity managementNet deposit outflow (inflow)
Reserve ratio decreases
(increase)
Increase (decrease) reserves
in the cheapest way possible
Sell (buy) assets
high transaction costs
Sell (extend) loans
adverse selectionSell (buy) securities
Call in (extend) loans
high opportunity costs
Increase (decrease) deposits
high transaction costs andadded operating costs
Borrow from discount window
(Fed)
Borrow from (lend to) Fed
Funds (other banks)
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3. Bank Management Principles
Asset management
Risk vs. Return: Default rate vs. Interest earned
Diversification: sectors, industries, markets,
regions
Reserve decision: invest vs. reserve
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3. Bank Management Principles
Liability management
Actively try to attract deposits
Sell large denomination (Saving Deposits) to
institutional investors
Borrow from other banks in the overnight
federal funds market
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3. Bank Management Principles
Capital adequacy management
Net worth vs. profit
ROA: net after-tax profit/assets
ROE: net after-tax profit/equity (capital, net worth)
Increased leverage (debt financing) increases assets (A = L + E)
Increased leverage (risk) increases ROE (return)
Regulators in many countries have therefore found it prudent to
mandate capital adequacy standards to ensure that some
bankers are not taking on high levels of risk in the pursuit of
high profits.
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3. Bank Management Principles
Capital adequacy management
Capital management to increase ROE:
Buy (sell) the banks stock in the open market, reducing(increasing) the number of shares outstanding, raising (decreasing)
capital and ROE.
Pay (withhold) dividends, decreasing (increasing) capital and ROE.
Increase (decrease) the banks assets (with capital and ROA held
constant), increasing (decreasing) ROE.
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3. Bank Management Principles
They must feel the thrill of totting up
a balanced book
A thousand ciphers neatly in a row.
When gazing at a graph that shows
the profits up
Their little cup of joy should overflow!
- Robert B. and Richard M. Sherman, from
A British Bank from Mary Poppins (1964)
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3. Bank Management Principles
Key Takeaways
Bankers must manage their banks liquidity (reserves regulatory and to
conduct business effectively), capital (adequacy regulatory and to buffer
against negative shocks), assets, and liabilities.
There is an opportunity cost to holding reserves, which pay no interest,
and capital, which must share the profits of the business.
While bankers left to their own judgments would hold reserves > 0 and
capital > 0, they might not hold enough to prevent bank failures at what
the government or a countrys citizens deem an acceptably low rate.
That induces government regulators to create and monitor minimumrequirements.
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4. Credit Risk
Chapter Objectives
Describe how bankers manage credit risk.
What is credit risk and how do bankers manage it?
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4. Credit Risk
Managing asymmetric information
A banker is a fellow who lends his umbrella
when the sun is shining and wants it back
the minute it begins to rain.
- Mark Twain (1835-1910)
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4. Credit Risk
No matter how good bankers are at asset, liability,
and capital adequacy management, they will be
failures if they cannot manage credit risk
Managing credit riskmanaging
Asymmetric information Adverse selection
Moral hazard
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4. Credit Risk
Managing asymmetric information
Screening create information/reduce asymmetry
reduce adverse selection embed information in binding contract
third-party verification
Specialization maximize efficiency of screening
Increase efficiency create exposure to systemic risk
Long-term loan commitments (line of credit)
reduce moral hazard other business services
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4. Credit Risk
Managing asymmetric information
Securitize collateral
reduce moral hazard compensatory balances
loan covenants
Credit rationing no credit at any interest rate
reduce adverse selection limit credit
reduce moral hazard
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4. Credit Risk
Key Takeaways
Credit risk is the chance that a borrower will default on a loan by not fully
meeting stipulated payments on time.
Bankers manage credit risk by screening applicants (taking applications
and verifying the information they contain), monitoring loan recipients,
requiring collateral like real estate and compensatory balances, and
including a variety of restrictive covenants in loans.
They also manage credit risk by trading off between the costs and benefits
of specialization and portfolio diversification.
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5. Interest-Rate Risk
Chapter Objectives
Describe how bankers manage interest-rate risk.
What is interest rate risk and how do bankers
manage it?
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5. Interest-Rate Risk
Financial intermediaries are exposed to interest rate risk
because their assets and liabilities are exposed to
interest rate risk.
Interest rate risk is determined by
the value of risk-sensitive assets,
the value of risk-sensitive liabilities, andthe change in interest rates.
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5. Interest-Rate Risk
Basic Gap Analysis
CP = (Ar Lr) x i
CP: changes in profitability
Ar: risk-sensitive assets
Lr: risk-sensitive liabilities
i: change in interest rates
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5. Interest-Rate Risk
Interestrates rise:
Asset valuesincrease
Interestrates fall:
Asset valuesdecrease
Interest
rates rise:Liability values
decrease
Interest
rates fall:Liability values
increase
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5. Interest-Rate Risk
If A > L andinterest ratesrise,
Profitabilityrises
If A < L andinterest ratesrise,
Profitability falls
If A > L and
interest ratesfall,
Profitability falls
If A < L and
interest ratesfall,
Profitabilityrises
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5. Interest-Rate Risk
To account for differences in maturities of assets andliabilities,
duration is used to estimate sensitivity to interest rate
changes:
%P = -%i x d
%P: percentage change in market value
%i: change in interest (NOT decimalized, i.e., represent
5% as 5 not .05. Also note the negative sign. The sign is
negative because, as we learned interest rates andprices are inversely related.)
d: duration (years).
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5. Interest-Rate Risk
Strategy Implications
Interest rates are expected to fall:
duration of liabilities short (borrow short) and
duration of assets long (lend long).
Interest rates are expected to rise:duration of liabilities long (borrow long) and
duration of assets short (lend short).
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5. Interest-Rate Risk
Key Takeaways Interest rate risk is the chance that interest rates may increase, decreasing
the value of bank assets.
Bankers manage interest-rate risk by performing analyses like basic gap
analysis, which compares a banks interest rate-risk sensitive assets and
liabilities, and duration analysis, which accounts for the fact that bankassets and liabilities have different maturities.
Such analyses combined with interest rate predictions tell bankers when
to increase or decrease their rate-sensitive assets or liabilities and
whether to shorten or lengthen the duration of their assets or liabilities.
Bankers can also hedge against interest-rate risk by trading derivatives, likeswaps and futures, and engaging in other off-balance sheet activities.
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6. Off the Balance Sheet
Chapter Objectives
Describe off-balance sheet activities and explain their importance.
What are off balance sheet activities and why do
bankers engage in them?
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6. Off the Balance Sheet
Hedge credit risk
Diversify revenue service fees
loan origination fees
sell loans (provide loan
guarantees)
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6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
Credit default swaps, which were invented by Wall Street in thelate 1990's, are financial instruments that are intended to cover
losses to banks and bondholders when a particular bond or
security goes into default -- that is, when the stream of revenuebehind the loan becomes insufficient to meet the payments that
were promised.
Credit default swaps are a type of credit insurance contract in
which one party pays another party to protect it from the risk of
default on a particular debt instrument. If that debt instrument (abond, a bank loan, a mortgage) defaults, the insurer compensates
the insured for his loss.
The New York Times, as quoted in Times Topics
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6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
The market for the credit default swaps has been enormous. Since2000, it has ballooned from $900 billion to more than $45.5 trillion
roughly twice the size of the entire United States stock market.
Also in sharp contrast to traditional insurance, the swaps are totallyunregulated.
The swaps' complexity and the lack of information in an unregulated
market added to the market's anxiety. Bond insurers like MBNA
and Ambac that had written large amounts of the swaps saw their
shares plunge in late 2007..
Michael Lewitt, September 16, 2008, The New York Times, as quoted in
Times Topics
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6. Off the Balance Sheet
The 2008 Crisis: Credit default swaps
Even before the market linkages among banks, other financial institutions
and non-financial businesses are fully re-established, we will need to start
unwinding the massive sovereign credit and guarantees put in place
during the crisis, now estimated at $7 trillion. The economics of such a
course are fairly clear. The politics of draining off that much credit support
in a timely way is quite another matter.
Alan Greenspan, Chairman,
U.S. Federal Reserve 1987-2006
In The Economist, December 18, 2008
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6. Off the Balance Sheet
Hedge interest rate risk
Derivatives trading Interest rate swaps
Currency trading
Trading on account
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6. Off the Balance Sheet
Key takeaways
Off-balance sheet activities like fees, loan sales, and derivatives
trading help banks to manage their interest-rate risk by providingthem with income that is not based on assets (and hence is off
the balance sheet).
Derivatives trading can be used to hedge or reduce interest-rate
risks but can also be used by risky bankers or rogue traders to
increase risk to the point of endangering a banks capital cushionand hence its economic existence.
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Bank Management - Snapshot
Chapter Summary A balance sheet is a financial statement
that lists what a company owns, its assets
or uses of funds, and what it owes, its
liabilities or sources of funds.
Major bank assets include reserves,
secondary reserves, loans, and other
assets.
Major bank liabilities include deposits,
borrowings, and shareholder equity.
Banks: lend (1) long (2) and (3) borrow (4)
short (5).
Like other financial intermediaries, banks
are in the business of transforming assets,of issuing liabilities with one set of
characteristics to investors and of buying
the liabilities of borrowers with another
set of characteristics.
-
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Chapter 9 Bank Management
Chapter Summary Generally, banks issue short-term
liabilities but buy long-term assets.
This raises specific types of management
problems bankers must be proficient at
solving if they are to succeed.
Bankers must manage their banks
liquidity (reserves regulatory and to
conduct business effectively), capital
(adequacy regulatory and to buffer
against negative shocks), assets, and
liabilities.
There is an opportunity cost to holding
reserves, which pay no interest, andcapital, which must share the profits of
the business.
-
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Chapter 9 Bank ManagementChapter Summary
While bankers left to their own judgmentswould hold reserves > 0 and capital > 0,
they might not hold enough to prevent
bank failures at what the government or a
countrys citizens deem an acceptably low
rate.
That induces government regulators tocreate and monitor minimum
requirements.
Credit risk is the chance that a borrower
will default on a loan by not fully meeting
stipulated payments on time.
Bankers manage credit risk by screening
applicants (taking applications and
verifying the information they contain),
monitoring loan recipients, requiring
collateral like real estate and
compensatory balances, and including a
variety of restrictive covenants in loans.
-
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Chapter 9 Bank Management
Chapter Summary They also manage credit risk by trading off
between the costs and benefits of
specialization and portfolio diversification.
Interest rate risk is the chance that
interest rates may increase, decreasing
the value of bank assets.
Bankers manage interest-rate risk by
performing analyses like basic gap
analysis, which compares a banks interest
rate-risk sensitive assets and liabilities,
and duration analysis, which accounts for
the fact that bank assets and liabilities
have different maturities. Such analyses combined with interest rate
predictions tell bankers when to increase
or decrease their rate-sensitive assets or
liabilities and whether to shorten or
lengthen the duration of their assets or
liabilities.
-
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Chapter 9 Bank Management
Chapter Summary Bankers can also hedge against interest-
rate risk by trading derivatives, like swaps
and futures, and engaging in other off-
balance sheet activities.
Off-balance sheet activities like fees, loan
sales, and derivatives trading help banks
to manage their interest-rate risk byproviding them with income that is not
based on assets (and hence is off the
balance sheet).
Derivatives trading can be used to hedge
or reduce interest-rate risks but can also
be used by risky bankers or rogue tradersto increase risk to the point of
endangering a banks capital cushion and
hence its economic existence.