CHAPTER 19 Bank Management. Chapter Objectives n Describe the underlying goal of bank management n Discuss how banks manage liquidity n Evaluate how banks.

CHAPTER

1919Bank

Management

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Describe the underlying goal of bank management

Discuss how banks manage liquidity Evaluate how banks manage interest rate risk Look at the techniques to manage credit risk Explain how banks manage capital

Goal of Bank ManagementGoal of Bank Management

The underlying goal of bank management is to maximize the wealth of the bank’s shareholders Maximizing the share price Agency costs

Investor costs incurred to promote managers’ interest in serving investors’ interest

Managers need incentives to seek shareholder’s best interests

Takeover target if stock price undervalued

Risks Faced By BanksRisks Faced By Banks

Value ofBank

Credit Risk

Interest RateRisk

LiquidityRisk

ValueRelated to

Cash Flowsand

Risk ofCash Flows

Capital orInsolvency

Risk

MarketRisk

Managing Liquidity RiskManaging Liquidity Risk

Risk of variability of return impacted by cost of providing liquidity for deposit outflows and/or loan demand

Maintain liquid assets and ability to borrow in financial markets

Securitizing loans provide liquidity Must forecast future cash flows

Managing LiquidityManaging Liquidity

Use of securitization to boost liquidity Selling off loans to trustee

Mortgage and automobile loans Trustee issues securities collateralized by the assets Loan payments pass through to holders of securities

Securitization turns future cash flows into immediate cash

Risk level related to guarantee provided to trust

Managing Interest Rate RiskManaging Interest Rate Risk

Risk of variability of returns caused by changing market interest rates

Interest rate risk comprised of price risk and reinvestment risk

Price risk = variability of returns caused by varying prices of assets

Security and loan values vary inversely with changes in market rates


Reinvestment risk = variability of return caused by changing interest rates on the reinvested coupon of securities or loans

Reinvestment risk and price risk cause realized returns to vary from expected

Price risk and reinvestment risk have an opposite impact on realized return when market interest rates change


Causes variability in net interest income (NII) and net interest margin (NIM)

NII = interest income - interest expense NIM = NII/assets Varying interest rates impact value of

financial assets, liabilities, and reinvestment returns

Varying interest rates cause repricing of loans, securities, and deposits impacting NII

Measuring Interest Rate RiskMeasuring Interest Rate Risk

$GAP measurement Duration measurement Regression analysis Benefits and limitations of each

$GAP easily constructed Duration measure more accurate Regression depends on future consistent

relationship of variables

GAP MeasurementGAP Measurement

$GAP = rate sensitive or repriceable assets (RSA) for a time period - rate sensitive liabilities (RSL)

Measures varied repriceability of interest-bearing assets, liabilities, and the cash flows of each

$GAP ratio = RSA - RSL +$GAP = asset sensitive position -$GAP = liability sensitive position

GAP, Varying Rates, NII AND NIMGAP, Varying Rates, NII AND NIM

+ $GAP - $GAP 0 $GAP

RSA > RSL RSA< RSL RSA = RSL

Interest Rates

Interest Rates

Interest Rates

Net Interest Income

Net Interest Income

Stable NetInterest Inc.

Duration MeasurementDuration Measurement

Adds consideration of cash flow, time value, and repricing

Duration = sum of discounted, time-weighted cash flows divided by the price of security or loan

Duration measures time-weighted maturity

Duration a better measure of risk than $GAP


Duration measurement Captures different degrees of sensitivity to interest

rate changes E.g. a 10-year zero coupon bond is more interest-

sensitive than a 10-year coupon bond Shorter maturities; lower duration Coupon interest and loan payments shorten duration

Duration of each type of bank asset and liability is determined

DURGAP = DURAS – [DURLIAB x LIAB/AS]


Regression analysis Estimates the historical relation between interest rates

and bank performance R = B0 + B1Rm + B2i + u

B2 = interest rate coefficient Positive coefficient suggests that past performance is

positively affected by rising interest rates Research suggest the opposite is true

Banks and S&L’s tend to have a negative gap NII and NIM adversely impacted with increasing interest rates


Determining whether to hedge interest rate risk Banks often use all three methods Banks use their analysis of gap with interest rate forecasts

to make their hedging decision

Methods of reducing interest rate risk Maturity matching of loans and deposits Using floating-rate loans Using interest rate futures contracts Using interest rate swaps Using interest rate caps


Methods of reducing interest rate risk Maturity matching

Match each deposit’s maturity with an asset of the same maturity

Difficult to implement Lots of short-term deposits

Using floating-rate loans Often increases credit risk and liquidity risk


Methods of reducing interest rate risk Using interest rate futures contracts

E.g. sale of T-bond futures by negative GAP bank to hedge interest rate increase results in a futures gain, offsetting adverse effects on NII

Hedging locks in NIM and negates benefit of falling rates. What about futures options?

Using interest rate swaps Arrangement to exchange periodic cash flows based on specific

interest rates Fixed loan interest-for-floating for negatively GAP bank to reduce

GAP exposure

Using interest rate caps

Managing Credit RiskManaging Credit Risk

Variability of return caused by delayed or nonpayment of loan/security interest or principal

Bank assembles portfolio of various types of loans seeking maximum net return per level of risk

Loan/security mix varies with desired risk level and economic conditions

Measuring Credit RiskMeasuring Credit Risk

Calculate Expected Loss Rate Per Type Of Loan and Total Loan Portfolio

Higher Default Premiums Charged For Higher Expected Loss Rate

Collateral may reduce expected loss rate Prime Plus Loan Pricing based on risk

profile

Diversifying Credit RiskDiversifying Credit Risk

Assemble loan portfolio of diverse Borrowers using portfolio theory: Varied income or employment Geographic locations Industries

Reduce total portfolio credit risk via diversification

Avoid concentration of loans Nationwide banking = diversification

Managing Credit RiskManaging Credit Risk

Diversifying credit risk International diversification of loans

May not help if the bank accepts loans from areas with very high credit risk

LDC’s in early 1980’s; Asian crises, 1997; Argentina, 2001

Selling loans Problem loans can be removed from the bank’s assets Selling price reflects expected default risk

Revising the loan portfolio in response to economic conditions

Managing Market RiskManaging Market Risk

Market risk results from the changes in value of securities due to changes in financial market conditions such as interest rates, exchange rates, and equity prices

Banks have increased exposure to derivatives and trading activities

Measuring market risk: Banks commonly use value-at-risk (VAR), which involves determining the largest possible loss that would occur in the event of an adverse scenario


Measuring market risk Bank revisions of market risk measurements

When changes in market conditions occur, such as increasing volatility, banks revise their estimates of market risk

How J.P. Morgan assesses market risk Calculates a 95 percent confidence interval for the

expected maximum one-day loss due to: Interest rates Exchange rates Equity prices Commodity prices Correlations between these variables


Methods of reducing market risk Reduce involvement in activities that cause high

exposure Take offsetting trading positions Sell securities that are heavily exposed to market

risk

Operating RiskOperating Risk

Operating risk is the variability of returns that may result from a failure in a bank’s general business operations Processing and sorting information Executing transactions Maintaining relationships with clients Dealing with regulatory issues Legal issues

Use of insurance, contracts, and other pure risk management techniques

Bank Capital ManagementBank Capital Management

Bank capital = bank net worth Purpose of bank capital

Absorbs losses on assets Provides base for leveraging debt Is a source of funds Serves to maintain confidence of financial markets

Regulators specify minimum capital per riskiness of assets

ROE = ROA x leverage measure

Management Based on ForecastsManagement Based on Forecasts

Some banks position themselves to benefit form expected changes in the economy

If managers expect a strong economy they may shift toward riskier loans and securities

Inaccurate forecasts have less effect on more conservative banks

Bank Restructuring to Manage RisksBank Restructuring to Manage Risks

Decisions are complex because they affect customers, employees, and shareholders

Bank acquisitions Common form of restructuring Quick way of achieving growth Advantages:

Economies of scale, diversification Managerial advantages

Disadvantages Purchase price may be too high; selling shareholder benefit Employee morale

Bank Restructuring to Manage RisksBank Restructuring to Manage Risks

Are bank acquisitions worthwhile? Studies show that the market reacts neutrally or

negatively to news of a bank acquisition May be due to:

Intra-market versus out-of-market merger Pessimism over whether efficiencies will be achieved Personnel clashes Price may be too high; selling shareholder capture added value

Integrated Bank ManagementIntegrated Bank Management

Bank management of assets, liabilities, and capital is necessarily integrated

An integrated management approach is also necessary to manage Liquidity risk, Interest rate risk, Credit risk Operating risk Capital or insolvency risk

Examples of Bank MismanagementExamples of Bank Mismanagement

Penn Square Bank Aggressive lending, concentrated in energy loans Limited diversification Energy sector problems caused defaults The bank provided new loans, part of which were

used to pay off old loans, recording them as “paid” rather than overdue

Could not continue this practice, so the bank failed in 1982


Continental Illinois Bank Provided loans in the energy sector originated by

Penn Square—financial market lost confidence Bank of New England

Concentrated on real estate loans in 1980s Overbuilding and reduced economic growth

resulted in defaults Even though other New England banks were

affected, the Bank of New England was more exposed because of heavy concentration in real estate


Implications of bank mismanagement Preceding examples should not imply that being

ultraconservative is preferred In a competitive environment, a bank may fall

behind A proper balance between risk and return should

be maintained

CHAPTER 19 Bank Management. Chapter Objectives n Describe the underlying goal of bank management n Discuss how banks manage liquidity n Evaluate how banks.

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credit risk n

rate risk n reinvestment

rates n

reinvestment risk n

rate risk n look

loans n reinvestment

expected n price risk

rate risk n causes variability