BANK MANAGEMENT BANK PERFORMANCE

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BANK MANAGEMENTBANK PERFORMANCE

• CHAPTERS 19, 20

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BANK MANAGEMENT

• What are the ways banks can increase their
  profits ?
• What are the two biggest dangers they face in
  doing so ?
• Why are banks trying to get larger and to expand
  their activities ?

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BANK PERFORMANCE EVALUATION

• Bank Profits
• P Loans x Realized Loan Yield minus Deposits x
  Cost per of Deposits - Fixed Expenses (e.g.,
  Selling, General, Administrative)
• RLY Contractual rate x Good Loan Fraction -
  (1-Recov. rate) x Bad Loan Fraction
• Consider an average rate of 12, 90 good loans
  and a recovery rate of 85 on bad loans. The RLY
  in this example is 9.3
• .12 x .9 - (1-.85) x .10 .093 or 9.3
• If the bank has a 100,000,000 portfolio, that
  equates to 9,300,000 in interest income after
  writing off 1,500,000 in bad loan losses
  (against 10,800,000 interest income)
• Cost of Deposits Interest paid plus the cost of
  free services
• Fixed Costs the cost of everything else the
  bank needs to run the business

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BANK PERFORMANCE EVALUATION

• Return on Equity ROE Profits / Equity
• Methods of Increasing ROE
• Lower Equity (increase leverage) a risky move in
  a volatile environment especially during
  periods of low profitability
• Equity Ratio equity / loans and investments
• Raise Profits by increasing revenue
• Increase contractual rates
• Lend more money need to increase deposits,
• Decrease free services or start charging for them
• Lower variable costs
• Lower fixed costs problem of indivisibility
• Tighten loan standards could result in lowering
  total loan portfolio
• Offer other low-cost high margin services i.e.,
  brokerage, insurance, etc
• Increasing size to get benefits of scale
• Securitizing collateralized loans retaining
  servicing fee income

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BANK PERFORMANCE EVALUATION

• Market Considerations
• Competition limits ability to raise loan rates,
  reduce services, or reduce deposit rates
• Increasing loan rates and decreasing deposit
  rates increases the Net Interest Margin
• Ability to make loans a function of
• (1) excess reserves or (2) required reserve
  ratio
• Customers know more than the bank
• Problem of asymmetric information
• Adverse selection raise rates and best quality
  customers may leave

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BANK PERFORMANCE EVALUATION

• The Risk-Return Tradeoff
• Competition and adverse selection limit ability
  to increase earnings from lending
• Other investments offer higher returns but carry
  interest rate risk
• Rather than lending, could invest depositors cash
  in interest earning securities
• As interest rates change, value of the investment
  portfolio changes
• What happens when value of the assets are less
  that value of liabilities?
• A Final Pass on Deposits, Reserves, and Liquidity
• Increasing deposits also increases variable costs
• Ability to make loans a function of excess
  reserves (cash in vault opportunity cost)
• Liquidity is necessary to service client demand
  for cash

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WHY BANKS FAIL

• The Most Frequently Given Reasons for Bank
  Failure
• Bank officer fraud
• Excessive Bad Loans
• Inadequate Liquidity / Inadequate Capital
• Deregulation and Resultant Increase in
  Competition
• Regulatory forbearance
• Non preparedness for increase in interest rate
  risk

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RECENT DEVELOPMENTS IN BANK MANAGEMENT

• Banking Regulation Seeks to Reduce Financial
  Shocks
• Banks must have higher levels of capital BIS
  (Bank for International Settlements)
• Tier 1 Book Value of Stock plus retained
  earnings
• Tier 2 Sum of Loan-Loss reserves and
  subordinated debt
• Total capital Tier 1 plus Tier 2
• How much a bank must have in each category a
  function of risk-adjusted assets
• Risk-Weighted Capital Requirements and Asset
  Types
• Cash and Government Securities 0 risk weight
• Loans 1.0 risk weight
• Mortgages 0.5 weight
• Inter bank deposits 0.2 weight

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RECENT DEVELOPMENTS IN BANK MANAGEMENT

• Bank Response to New Capital Requirements
• Issuance of new stock
• Merger with a stronger bank
• Shrinking the Balance Sheet. reduction in
  assets, w/o changes in equity, increases equity
  ratio or pushing for acquisition by larger bank
• Risk weights increase attractiveness of
  Government securities. (also subjects them to
  interest rate risk)
• Shifting to riskier assets within each category
• Take on more interest- and exchange-rate risk
• Take on risk as Forward Intermediary i.e.,
  selling derivatives

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RISK IN BANK PORTFOLIOS

• Examining the Proportion of Rate Sensitive Assets
  and Liabilities
• GAP Analysis ? Changes in Income
• GAP Rate Sensitive Assets (RSA) Rate
  Sensitive Liabilities (RSL)
• DI GAP Di
• 2. Rate Sensitive Assets
• Short-Term Loans (Maturities 1 year or less)
  commercial or consumer
• Variable Rate Mortgages
• The proportion of fixed rate mortgages that are
  repaid early
• The proportion of auto loans paid early
• Rate Sensitive Liabilities
• Money Market Deposits
• Variable Rate CDs and CDs maturing in 1 year or
  less
• Borrowings with maturities 1 year or less

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RISK IN BANK PORTFOLIOS

• Interest Rate Changes and GAP
• If a financial institution has more rate
  sensitive liabilities (RSL) than rate sensitive
  assets (RSA), then the GAP will be negative
• GAP RSA RSL
• If RSL gt RSA, then GAP lt 0 (negative)
• Any increases in Interest rates will reduce the
  GAP (or net interest rate margin) and result in
  net income decline

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RISK IN BANK PORTFOLIOS

• Interest Rate Changes and GAP (Continued)
• If a financial institution has more rate
  sensitive Assets (RSA) than rate sensitive
  liabilities (RSL), then the GAP will be positive
  
• GAP RSA RSL
• If RSA gt RSL, then GAP gt 0 (positive)
• Any increases in Interest rates will increase the
  GAP (or net interest rate margin) and result in
  net income growth.

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RISK IN BANK PORTFOLIOS

• Bank Profits a function of interest rate
  expectations
• If interest rates expected to go up, then
  allocate assets to short-term loans ? rollover at
  higher rates
• If interest rates expected to go down, allocate
  assets to long-term loans ? less rollover
• B. Forecasting interest rates is important
• Effects on GAP of Proportions of RSA and RSA
• Magnitude of excess reserves is key to loss
  containment strategy

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MANAGING INTEREST RATE RISK (Gap)

• Potential Strategies
• Maturity matching would drive Commercial banks
  to short-term loans
• Floating-rate loans unpopular with borrowers
• Financial Futures high leverage, high risk
  (basis risk)
• Interest Rate Swaps potentially risky if wrong
  on expectations or arrangements
• The Interest Rate Swap
• Dealing with changes induced in Interest Revenues
  and Interest Expense resulting from changes in
  market rates
• Exchanging one set of interest payment for
  another SWAP
• The Scenarios for Interest rate Swaps
• Long-Run increase in interest rates decreases
  the gap
• Long-Run decrease in interest rates increases
  the gap

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MANAGING INTEREST RATE RISK (The Gap)

• Types of SWAPS
• Fixed rate for Floating Rate Swap rates
  calculated at time of swap
• Forward Swap setting the rates now for future
  swap
• Swaptions hybrid arrangements for early
  termination
• Callable Swap party making fixed payments option
  to terminate before maturity Desirable if
  interest rates decline
• Putable Swap party making floating payments
  option to terminate before maturity Desirable if
  interest rates increase
• Basis Risk in Swap Transactions
• Recall that gains and losses for parties to a
  futures-type arrangement stem from
• Changes in basis
• If fixed rates go up more slowly that variable
  rates, basis decreases resulting in losses to the
  buyer (institution exchanging fixed rate receipts
  for variable