Chapter 9: Bank Management

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Chapter 9 Bank Management

• Chapter Objectives
• Explain what a balance sheet and a T-account are.
• Explain what banks do in five words and also at
  length.
• Describe how bankers manage their banks balance
  sheets.
• Explain why regulators mandate minimum reserve
  and capital ratios.
• Describe how bankers manage credit risk.
• Describe how bankers manage interest rate risk.
• Describe off-balance sheet activities and explain
  their importance.

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• Chapter Objectives
• Explain what a balance sheet and a T-account are.
• What is a balance sheet and what are the major
  types of bank assets and liabilities?

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• Liabilities money that companies borrow in
  order to buy assets
• Equity (Net Worth or Capital) residual that
  makes the two sides of the equation balance
  (banks have little)
• A company is economically viable if what it owns
  exceeds the value of what it owes (Equity is
  positive)
• A company is not economically viable if the value
  of what it owes exceeds the value of what it
  owns. (Equity is negative)
• The value of assets and liabilities (equity)
  fluctuates due to changes in interest rates and
  asset prices

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• Reserves In this context, cash funds that
  bankers maintain to meet deposit outflows and
  other payments
• Required reserves A minimum amount of cash funds
  that banks are required by regulators to hold
• Secondary reserves Noncash, liquid assets, like
  government bonds, that bankers can quickly sell
  to obtain cash

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Assets

• Commercial banks own
• Reserves of cash and deposits with the Fed
• Secondary reserves of government and other liquid
  securities
• Loans to businesses, consumers, and other banks
• Other assets, including buildings, computer
  systems, and other physical stuff

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Liabilities

• The right-hand side of the balance sheet lists a
  banks liabilities or the sources of its fund
• Deposits
• Transaction deposits negotiable order of
  withdrawal accounts and money market deposit
  accounts
• Non-transaction deposits savings, negotiable
  certificates of deposit
• Time deposits

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Liabilities
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T-Accounts

• Asset transformation and balance sheets provide
  us with only a snapshot view of a financial
  intermediarys business
• Intermediaries, like banks, are dynamic places
  where changes constantly occur
• The easiest way to analyze this dynamism is via
  so-called T-accounts
• Simplified balance sheets that list only changes
  in liabilities and assets

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• Chapter Objectives
• Describe how bankers manage their banks balance
  sheets.
• Explain why regulators mandate minimum reserve
  and capital ratios.
• What are the major problems facing bank managers
  and why is bank management closely regulated?

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Bank management risks

• While earning profits and managing liquidity and
  capital, banks face two major risks
• Credit risk - The risk of borrowers defaulting on
  the loans and securities it owns
• Interest rate risk - The risk that interest rate
  changes will decrease the returns on its assets
  and/or increase the cost of its liabilities

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• Net deposit outflow (inflow)
• ?
• Reserve ratio decreases (increase)
• ?
• Increase (decrease) reserves
• ?
• in the cheapest way possible

• Sell (buy) assets
• high transaction costs
• Sell (extend) loans
• adverse selection
• Sell (buy) securities
• Call in (extend) loans
• high opportunity costs
• Increase (decrease) deposits
• high transaction costs and added operating costs
• Borrow from discount window (Fed)
• Borrow from (lend to) Fed Funds (other banks)

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• Entails the usual trade-off between risk and
  return
• Bankers should diversify, make loans to a variety
  of different types of borrowers,
• Preferably in different geographic regions
• Bankers need secondary reserves, some assets that
  can be quickly and cheaply sold to bolster
  reserves if need be

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• No matter how good bankers are at asset,
  liability, and capital adequacy management, they
  will be failures if they cannot manage credit
  risk.
• Managing credit risk ? managing
• Asymmetric information
• Adverse selection
• Moral hazard

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• Screening create information/reduce asymmetry
• reduce adverse selection embed information in
  binding contract
• third-party verification
• Specialization maximize efficiency of screening
• Increase efficiency create exposure to systemic
  risk
• Long-term loan commitments (line of credit)
• reduce moral hazard other business services

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• Securitize collateral
• reduce moral hazard compensatory balances
• loan covenants
• Credit rationing no credit at any interest rate
• reduce adverse selection limit credit
• reduce moral hazard
•  

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• Financial intermediaries are exposed to interest
  rate risk because their assets and liabilities
  are exposed to interest rate risk.
• Interest rate risk is determined by the value of
  risk-sensitive assets, the value of
  risk-sensitive liabilities, and the change in
  interest rates.

17

• Chapter Objectives
• Describe off-balance sheet activities and explain
  their importance.
• What are off-balance-sheet activities and why do
  bankers engage in them?

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• Banks and other financial intermediaries take
  off-balance-sheet positions in derivatives
  markets, including futures and interest rate
  swaps
• Use derivatives to hedge their risks
• Try to earn income should the banks main
  business suffer a decline if, say, interest rates
  rise
• Hedge their interest rate risk by engaging in
  interest rate swaps
• Speculate in derivatives and the foreign exchange
  markets, hoping to make a big killing

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• Credit default swaps, which were invented by
  Wall Street in the late 1990's, are financial
  instruments that are intended to cover losses to
  banks and bondholders when a particular bond or
  security goes into default -- that is, when the
  stream of revenue behind the loan becomes
  insufficient to meet the payments that were
  promised.
• Credit default swaps are a type of credit
  insurance contract in which one party pays
  another party to protect it from the risk of
  default on a particular debt instrument. If that
  debt instrument (a bond, a bank loan, a mortgage)
  defaults, the insurer compensates the insured for
  his loss.
• The New York Times, as quoted in Times Topics

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• The market for the credit default swaps has been
  enormous. Since 2000, it has ballooned from 900
  billion to more than 45.5 trillion roughly
  twice the size of the entire United States stock
  market.
• Also in sharp contrast to traditional insurance,
  the swaps are totally unregulated.
• The swaps' complexity and the lack of information
  in an unregulated market added to the market's
  anxiety. Bond insurers like MBNA and Ambac that
  had written large amounts of the swaps saw their
  shares plunge in late 2007..
• Michael Lewitt, September 16, 2008, The New York
  Times, as quoted in Times Topics