Bank Management Marc PrudHomme University of Ottawa Last update: 14/09/12.

Bank Management

Marc Prud’HommeUniversity of Ottawa

Last update: 14/09/12

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Preview Banks and other depository institutions play an

important role in channelling funds to borrowers with important productive investment opportunities.

They are important in ensuring that the financial system and the economy run smoothly and efficiently.

In this chapter: Examine how banks maximise profits. How they make loans. How they acquire funds. How they manage their liabilities and assets. How they earn income. These principles apply to other depository institutions.

Bank management

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The balance sheet

To understand the workings of a bank, one must examine its balance sheet.

Balance sheet: List of assets (uses of funds) and liabilities (sources of funds)

Total assets = total liabilities + capital Banks make profit by earning an interest

rate on their securities and loans that is higher than the expenses associated with its liabilities.

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Finance Act: 1914

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Liabilities Demand and notice deposits (20% of liabilities):

Chequing accounts and savings accounts with chequing privileges.

Fixed-term deposits (50% of liabilities): Savings accounts and time deposits. (CDs or term deposits)

Borrowing: Bank of Canada (advances), Other banks (settlement balances), and corporations (Banker’s acceptance).

Bank capital (5% of liabilities): This is the banks net worth = value of assets - value of liabilities. The funds are raised by selling equity. It is a cushion

against a drop in the value of assets. Loan loss reserves are important element

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Assets Cash reserves: Settlement balances at the Bank of Canada

and Vault cash. Deposits at other banks: Interbank deposits. About 85% of

these interbank deposits are in foreign currencies. Cash items in the process of collection: The float or item in

transit. TOTAL cash reserves (6% of bank assets) = Cash reserves +

Deposits at other banks + Cash items in the process of collection.

Total reserves accounted for 20% of assets 20 years ago. Although banks are not required to hold reserves, they do =

Desired reserves. They hold reserves to satisfy predictable clearing drains and

predictable across-the-counter and ATM withdrawals. They hold reserves to satisfy unpredictable withdrawals of

liability holders, i.e, to minimize banker’s risk!

Bank management

7Operation of a bank

In general to maximize profits, a bank will make profits by selling liabilities with one set of features and using the proceeds to buy assets with different features = ASSET TRANSFORMATION.

The key characteristics of a bank is its ability to buy assets by issuing their own deposit liabilities. Examples follow…with T-accounts.

Bank management

8Operation of a bank

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9Operation of a bank

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10Operation of a bank

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11General principles of bank management

How does the bank manage its assets and liabilities in order to maximize profits?

The manager has 4 issues he or she must be sensitive to: Liquidity management: The bank must ensure that it has

enough cash when there deposit outflows. To keep enough cash on hand, the bank acquires liquid assets to meet its obligations to depositors.

Asset management: The bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and diversifying.

Liability management: The bank must acquire liabilities at a low cost.

Capital adequacy management: The manager must decide on the amount of capital the bank should maintain and then acquire the needed capital.

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12 Bank management

What can the manager do if a person withdraws money from their account? Lets assume a reserve ratio of 10%. This is the initial balance sheet:

After the $10 are withdrawn from the deposit account then the balance sheet will looks like this:

Assets Liabilities

Reserves$20

Loans$80Securities

$10

Deposits$100Capital $10

Assets Liabilities

Reserves$10

Loans$80Securities

$10

Deposits$90

Capital $10

Liquidity management and the role of reserves.

13Liquidity management and the role of reserves.

Bank management

What can the bank do in cases where there are no excess reserves? This is the balance sheet at the start:

After the $10 are withdrawn from the deposit account then the balance sheet will looks like this:

No more reserves left, the bank has a problem! Normally should have $90 x 10% = $9

There are 4 possible options (or quick fixes):

Assets Liabilities

Reserves$10

Loans$90Securities

$10

Deposits$100Capital $10

Assets Liabilities

Reserves$0

Loans$90Securities

$10

Deposits$90

Capital $10

14Liquidity management and the role of reserves.

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Option 1: Borrows from other banks in the overnight market

Option 2: sell securities

Assets Liabilities

Reserves$9

Loans$90Securities

$10

Deposits$90

Overnight loan $9Capital

$10

Assets Liabilities

Reserves$9

Loans$90Securities$1

Deposits$90Capital $10

15Liquidity management and the role of reserves.

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Option 3: Advances from the Bank of Canada, which involves two costs The Bank rate More monitoring from the Regulators

Option 4: Sell loans or calling in loans (yes, banks can call in loans, see here:

http://www.bizjournals.com/sanfrancisco/blog/2012/01/bank-of-america-small-business-lending.html?page=all

Assets Liabilities

Reserves$9

Loans$90Securities

$10

Deposits$90

Advances BoC $9Capital

$10

Assets Liabilities

Reserves$9

Loans$81Securities

$10

Deposits$90Capital $10

16Liquidity management and the role of reserves.

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We now know why banks will want to hold excess reserves.

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.

The cost of the insurance is its opportunity cost, which is the earnings foregone by not holding income-earning assets such as loans and securities.

17Asset management

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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. There are 4 basic methods used by banks to accomplish these 3 goals:

Banks find borrowers who will pay higher interest rates and are unlikely to default on their loans.

Banks try to buy securities with high returns and low risk.

18Asset management

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By managing their assets, banks try to lower risk by diversifying. They purchase many types of assets, and approve many types of loans in many geographical locations.

Banks will manage the liquidity of their assets so that it can pay depositors when there are deposit outflows. It will thus hold liquid assets even if they have a lower return as long as they are more liquid.

19Liability management

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Yesterday’s banks did not pay too much attention to liability management. It used to take its liabilities (or deposits) as a given. With the development of negotiable CDs in the early 60s, banks could acquire funds quickly and did not have to rely as much on deposits as a source of financing.

Today, banks are more active with regards to liability management by setting target goals for their asset growth and then acquiring the funds to finance this growth by issuing liabilities as they are needed.

20CAPITAL ADEQUACY MANAGEMENT

Bank management

Banks need to make decisions about the amount of capital they need for three reasons: Bank capital helps prevent bank failure. Bank capital affects the returns for the owners

(shareholders) of the bank. Regulatory authorities require a minimum

amount of bank capital.

21CAPITAL ADEQUACY MANAGEMENT

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TO PREVENT FAILURE : Assume 2 banks with the same balance sheet except that “High Capital” has a ratio of capital to assets of 10 % while the “Low Capital” bank has its ratio set at 4 %.

22CAPITAL ADEQUACY MANAGEMENT

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TO PREVENT FAILURE : Assume 2 banks with the same balance sheet except that “High Capital” has a ratio of capital to assets of 10 % while the “Low Capital” bank has its ratio set at 4 %.

23CAPITAL ADEQUACY MANAGEMENT

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Now assume that $5 of loans has to be written off. This means that the value of assets falls by $5, and

therefore the bank capital (assets - liabilities) must fall by $5.

24How bank capital affects returns to equity holders

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Shareholders want to know if the bank is well managed, they need a good measure of bank profitability.

The basic measure of profitability is RETURN ON ASSETS (ROA): Net profit after taxes per dollar of assets. ROA = Net profit after taxes/Assets.

The shareholders are more preoccupied with their earnings on equity investment:

RETURN ON EQUITY (ROE): Net profit after taxes per dollar of equity capital. ROE = Net profit after taxes/Equity capital.

25How bank capital affects returns to equity holders

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There is a relationship between ROA and ROE, which is defined by the Equity multiplier (EM): the amount of assets per dollar of equity capital.

Equity Multiplier (EM) = Assets/equity capital. ROE = ROA x EM => (net profit after taxes/equity capital)

= (net profit after taxes/assets) x (assets/equity capital)

More on the equity multiplier here: http://www.investopedia.com/terms/e/equitymultiplier.asp#

axzz2DSaA15y0

26How bank capital affects returns to equity holders

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ROE = ROA x EM From this equation we see that the smaller the amount of

capital the higher the ROE. The “high capital” has at the start $100 of assets and $10

of equity for an EM = 10. The “low capital” has at the start $100 of assets and 4 $ of

equity for an EM = 25. If the return on equity for both banks is assumed to be 1%

(which means they are equally run). For the “high capital”, the ROE = 10 x 1% = 10% For the “low capital”, the ROE = 25 x 1% = 25% “Low capital” shareholders are happier.

27How bank capital affects returns to equity holders

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Trade-off between safety and return to equity holders: Capital has benefits and costs.

Bank capital benefits the owners of the bank in that it makes its investment safer by reducing the likelihood of bankruptcy.

Bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets.

When determining the level of capital, bank managers must decide how much of the increased safety resulting from the higher capital they are willing to trade-off against the lower return on equity that comes with the higher capital.

28Managing Credit Risk

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Sound bank management practices require that banks make loans that are paid in full. Therefore, banks must be aware and overcome of the

adverse selection and moral hazard problems to increase profits.

Adverse selection: Those more likely to produce an adverse outcome are the ones most likely to be selected.

Moral hazard: Lenders might engage in undesirable activities from the lenders point of view. The loan will therefore be subject to the hazards of default.

29Managing Credit Risk

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Increase volatility of interest rate risk in the 80s have led banks has heightened banks awareness about exposure to interest-rate risk.

Interest-rate risk: the sensitivity of earnings and returns associated with changes in interest rates.

Example:

30Managing Credit Risk

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Example If Interest rates go from 10% à 15%. Revenues from assets: (10% x $20 = $2) to (15% x $20

= 3 $) Payments to liabilities (10% x $50 = $5) to (15% x $50 =

$7,5) Changes in profits $1 - $2.5 = - $1.5 If Interest rates go from 10% à 5%. Changes in profits $2.5 - $1 = + $1.5

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline

in interest rates will raise bank profits.

31Managing Credit Risk

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GAP and DURATION Analysis GAP analysis Basic GAP analysis: The sensitivity of bank profits to

changes in interest rates can be measured by GAP analysis. GAP = IRSA - IRS and change in Profits = change in i

change in GAP From example: GAP = 20 $ - 50 $ = - $30 By multiplying the GAP times the change in the interest

rate, we obtain the effect on bank profits: - $30 x 5 % = - $1.5

32Off-Balance Sheet Activities

Bank management

In most recent years banks have been engaging on OBSA to increase profits.

OBSA: Increasing revenues and profits by trading financial instruments, collecting fees and loan sales. Activities that affect revenues but do not appear on the balance

sheet of the bank. Fee income: foreign exchange trades for customers,

overdraft protection, fees on deposit accounts, etc. Trading activities and risk management techniques: Bank

trading in financial futures and interest rate swaps.

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END

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