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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. – PowerPoint PPT presentation

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Title: Chapter 9: Bank Management


1
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.

2
  • 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?

3
  • 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

4
  • 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

5
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

6
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

7
Liabilities
8
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

9
  • 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?

10
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

11
  • 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)

12
  • 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

13
  • 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

14
  • 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

15
  • 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
  •  

16
  • 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?

18
  • 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

19
  • 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

20
  • 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
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