Bank

1
19

• Bank
• Management

2
Chapter 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

3
Goal of Bank Management

• The underlying goal of bank management is to
  maximize the wealth of the banks shareholders
• Maximizing the share price
• Agency costs
• Investor costs incurred to promote managers
  interest in serving investors interest
• Managers need incentives to seek shareholders
  best interests
• Takeover target if stock price undervalued

4
Risks Faced By Banks
Value of Bank
Value Related to Cash Flows and Risk of Cash Flows
5
Managing 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

6
Managing 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

7
Managing 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

8
Managing Interest Rate Risk

• 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

9
Managing Interest Rate Risk

• 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

10
Measuring 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

11
GAP 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

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GAP, Varying Rates, NII AND NIM
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Duration 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

14
Managing Interest Rate Risk

• 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

15
Managing Interest Rate Risk

• 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 SLs tend to have a negative gap
• NII and NIM adversely impacted with increasing
  interest rates

16
Managing Interest Rate Risk

• 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

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Managing Interest Rate Risk

• Methods of reducing interest rate risk
• Maturity matching
• Match each deposits 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

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Managing Interest Rate 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

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Managing 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

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Measuring 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

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Diversifying 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

22
Managing Credit Risk

• Diversifying credit risk
• International diversification of loans
• May not help if the bank accepts loans from areas
  with very high credit risk
• LDCs in early 1980s Asian crises, 1997
  Argentina, 2001
• Selling loans
• Problem loans can be removed from the banks
  assets
• Selling price reflects expected default risk
• Revising the loan portfolio in response to
  economic conditions

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Managing 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

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Managing Market Risk

• 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

25
Managing Market Risk

• 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

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Operating Risk

• Operating risk is the variability of returns that
  may result from a failure in a banks 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

27
Bank 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

28
Management 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

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Bank 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

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Bank 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

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Integrated 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

32
Examples 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

33
Examples of Bank Mismanagement

• Continental Illinois Bank
• Provided loans in the energy sector originated by
  Penn Squarefinancial 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

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Examples of Bank Mismanagement

• 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