fund management in banks

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Copyright© 2006 John Wiley & Sons, Inc . 1

Power Point Sl ides for:

Financial Institutions, Markets, andMoney, 9 th Edition

Authors: Kidwell, Blackwell, Whidbee &

PetersonPrepared by: Babu G. Baradwaj, Towson University

And

Lanny R. Martindale, Texas A&M University




Bank Earnings: Net I nterest I ncome

Loan interest and fees represent the main source of bank revenue, followed by interest on investmentsecurities.

Interest paid on deposits is the largest expense,followed by interest on other borrowings.

Net interest income is the difference between

gross interest income and gross interest expense.This margin is relatively stable because theinterest rates banks earn and pay are largely set bythe market.




Bank Earnings: Provision for L oan L osses

Provision for loan losses is an expense itemthat adds to a bank’s loan loss reserve (acontra-asset account).

Banks provide for loan losses in anticipationof credit quality problems in the loan

portfolio.

Loans are written off against the loan lossreserve




Bank Earnings: Non-i nterest income and expense

Noninterest income includes fees andservice charges. This source of revenue hasgrown significantly in importance.

Noninterest expense includes personnel,occupancy, technology, and administration.These expenses have also grown in recentyears.




Bank Performance

Trends in profitability can be assessed byexamining return on average assets (net income / average total assets) over time.

Another measure of profitability is return onaverage equity .

In the mid- and late-1990s, bank profitabilityimproved significantly.




Dilemma: Profi tabili ty vs. 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:shareholdersdepositorsregulators

Each with their own interest in profitability andsafety.




Solvency and L iquidity

Solvency: Maintaining the momentum of a going

concern, attracting customers and financing.A firm is insolvent when the value of its liabilitiesexceeds the value of its assets.Banks have relatively low capital/asset ratios but

generally high-quality assets .

Liquidity: the ability to fund deposit withdrawals,loan requests, and other promised disbursementswhen due.

A bank can be profitable and still fail because of illiquidity.




Conf licting Demands

A bank must balance profitability, liquidity, and

solvency.

Bank failure can result from excessive losses onloans or securities -- from over-aggressive profitseeking. But a bank that only invests in high-qualityassets may not be profitable.

Failure can also occur if a bank cannot meetliquidity demands. If assets are profitable butilliquid, the bank also has a problem.

Bank insolvency often leads to bank illiquidity.




L iquidity M anagement

Banks rely on both asset sources of liquidityand liability sources of liquidity to meet thedemands for liquidity.

The demands for liquidity includeaccommodating deposit withdrawals,

paying other liabilities as they come due,and accommodating loan requests.




Asset M anagement

classifies bank assets from very liquid/low

profitability to very illiquid/profitablePrimary Reserves are noninterest bearing, extremelyliquid bank assets

Secondar y Reserves are high-quality, short-term,marketable earning assets

Bank Loans are made after absolute liquidity needsare met

After loan demand is satisfied, funds are allocated toIncome Investments that provide income, reasonablesafety, and some liquidity, if needed




L iabil i ty M anagement

Assumes bank can borrow its liquidity needs at

will in money markets by paying market rate or better

Liability levels (borrowing) may be quicklyadjusted to loan (asset) needs or depositvariability

Bank liability liquidity sources include “non -deposit borrowing" (e.g. Fed funds, etc.)

LM supplements asset management, but does notsupersede it




Defini tion of Bank Capital

Tier 1 capital or “core” capital includes commonstock, common surplus, retained earnings, non-cumulative perpetual preferred stock, minorityinterest in consolidated subsidiaries, minusgoodwill and other intangible assets.

Tier 2 capital or “supplemental” capital includescumulative perpetual preferred stock, loan lossreserves, mandatory convertible debt, andsubordinated notes and debentures .




F unctions of Bank Capital

Absorb losses on assets (loans) and limit therisk of insolvency.Maintain confidence in the banking system.Provide protection to uninsured depositors

and creditors.Ultimate source of funds and leverage baseto raise depositor funds.




Regulatory Capital Standards

As capital requirements have increased, regulators

have also implemented risk-based capitalstandards.

Capital is measured against risk-weighted assets .

Risk-weighting is a measure of total assets thatweighs high-risk assets more heavily.

The purpose is to require high-risk banks to hold

more capital than low-risk banks.




M inimum Capital Requi rements

Ratio of Tier 1 capital to risk-weighted assets must be at least 4%

Ratio of Total Capital ( Tier 1 plus Tier 2 ) torisk-weighted assets must be at least 8%.

Undercapitalized banks receive extra

regulatory scrutiny; regulators may limitactivities, intervene in management, or evenrevoke charter.




M anaging 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 concernsthe aggregate credit risk of all the loans in the

bank’s portfolio.Banks must manage both dimensions effectivelyto be successful.




M anaging Credit Risk of I ndividual L oans

Begins with lending decision (and 5 Cs asdiscussed in Chapter 13)

Requires close monitoring to identify

problem loans quicklyThe goal is to recover as much as possibleonce a problem loan is identified.




M anaging Credit Risk of L oan Portfolio

Internal Credit Risk Ratings are used toidentify problem loansdetermine adequacy of loan loss reserves

price loans

Loan Portfolio Analysis is used to ensurethat banks are well diversified.

Concentration ratios measure the percentageof loans allocated to a given geographiclocation, loan type, or business type.




M easur ing I nterest Rate Risk: M aturi ty GAP Analysis

Assets and liabilities which “reprice”(change interest rate in a specified period of time) are identified as “rate - sensitive”.

A bank's Maturity GAP is computed bysubtracting rate sensitive liabilities (RSL)from rate sensitive assets (RSA).




GAP = RSA – RSL ; Posi tive Gap

Positive GAP = RSA > RSL Net interest income will decline if interestrates fallMore assets than liabilities repricedownward if interest rates decline, thusreducing net interest income




GAP = RSA – RSL ; Negative Gap

Negative GAP = RSA < RSL Net interest income will decline if interestrates increaseMore liabilities than assets reprice upwardif interest rates increase, thus reducing netinterest income.

M i I t tR t Ri k D ti GAPA l i




M anaging I nterest Rate Risk:Duration GAP Analysis

Maturity GAP provides only an approximate rule for

analyzing interest rate risk.

Duration GAP analysis matches cash flows and their

repricing capabilities over a period of time.

The percentage change in the value of a portfolio,given a change in interest rates, is proportional to theduration of the portfolio multiplied by the change ininterest rates.




Positive Duration GAP

Assets have longer duration than liabilities; bank expects

interest rates to fall

If interest rates rise — More assets than liabilities will lose value,

Thus reducing the value of the bank’s equity

If interest rates fall-More assets than liabilities will gain value,

Thus increasing the value of the bank’s equity

N ti D ti GAP




Negative Dur ation GAP

Liabilities have longer duration than assets; bank expects

interest rates to rise.

If interest rates rise — More liabilities than assets will lose value,

Thus increasing the value of the bank’s equity

If interest rates fall — More liabilities than assets will gain value,

Thus reducing the value of the bank’s equity




Zero Dur ation Gap

Bank is immunized against interest raterisk.

Easier in theory than in practice.

Duration GAP manipulation is a complex

tool, used more by large banks.

H d i I R Ri k A S i i




H edging I nterest Rate Risk: Asset-Sensitive

Asset-sensitive with positive maturity GAP;

negative duration GAP; hurt by falling rates:Buy financial futures--falling rates increase value of contract, offsetting negative impact of GAP

Buy call options on financial futures

Swap to increase their variable-rate cash outflows andincrease their fixed-rate (long-term) cash inflows

Lengthen repricing of assets; shorten repricing of liabilities

H dgi gI t tR t Ri k L i bili t S iti




H edging I nterest Rate Risk: L iabili ty-Sensitive

Liability-sensitive with negative maturity GAP;

positive duration GAP;--hurt by rising rates:Sell financial futures--increasing rates would increasevalue of futures contracts, offsetting the negativeimpact of GAP situation

Buy put options on financial futures

Swap long-term, fixed-rate payments for variable-rate payments

Shorten repricing of assets; lengthen repricing of liabilities

fund management in banks

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