lecture 2 banking and the management of financial institutions

7/31/2019 Lecture 2 Banking and the Management of Financial Institutions

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Lecture 2: Banking and the

management of financial institutions

References

From the custom text:Deposit-taking institutions (Valentine et al)Banking and the management of financialinstitutions (Mishkin)

Other reference:Suanders, A. and M. Cornett (2012), FinancialMarkets and Institutions, 5th edition, McGraw-Hill Irwin, pp. 391-400.

A links to the above reference will be madeavailable on MyUni.

The 3 Rs of Bank Management

Maximise RETURNS to shareholders

subject to:an acceptable level of RISK

whilst meeting REGULATORYREQUIREMENTS

In general, higher returns are associatedwith higher risks

conflicts of interest for stakeholders


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The business of banking

To fund activities banks:

take deposits and issue debt securities(issue liabilities);

and banks use these funds to:

make loans and invest in debt securities(purchase assets)

The bank balance sheet

Assets = Liabilities + Capital (Equity)

i.e. A = L + E

Capital risk is risk of bank failure(insolvency) => L > A i.e. E < 0

banks & regulators place emphasison maintaining strong capital positions

Copyright 2007 Pearson Addison-Wesley. Allrights reser ved. 9-6


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The bank balance sheet (continued)

Banks must list A & L in order of liquidity frommost liquid to least liquid.

Liquid A make it easier for banks to respond tounanticipated deposit outflows.

A high proportion of liquid L risk of failure(especially through deposit outflows).

Basic BankingMaking a Profit

Asset transformation - selling liabilities withone set of characteristics (liquidity, risk, size &return) and using the proceeds to buy assetswith a different set of characteristics.

Liquidity and maturity transformation: Banksborrow short (liquid deposits) and lend long(illiquid loans) liquidity risk.

Size: Typically, funds from small deposits fundlarger loans

Basic BankingMaking a Profit(continued)

Return

= Net interest incomeDerived from Interest spread (loan rate less

deposit rate)

+ fees

+ income earned from securities portfolio

+ money earned from off-balance sheetactivities


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Banks need to manage:

Liquidity

Assets

Liabilities

Capital Adequacy

Credit Risk

Interest-rate Risk

Liquidity Risk

The risk that a bank will have insufficientliquid funds to pay depositors or meetother payment commitments as they falldue.

Liquidity Management:Ample Reserves

Australian banks must have positive balances

(Reserves) in exchange settlement accounts(ESAs) at RBA.

If a bank has ample reserves, a depositoutflow

L = A no in E


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Liquidity Management (Short-term): Shortfall in Reserves

Reserves are a legal requirement (in thesense that balances in ESAs are not allowed

to be negative; there is no reserve ratio inAustralia) and a potential shortfall must beeliminated.

Liquidity management (continued)

In order to obtain same-day funds, bankscan:

Borrow from other banks which havepositive balances in ESAs in overnightmarket at cash rate

Enter into repurchase agreements(repos) with RBA

Liquidity Management (continued)

Banks can also obtain additional liquidity over

the longer-term by:

Direct borrowing from other participants infinancial markets (next-day funds can beobtained this way)

Issuing short-term & long-term debt securities

Calling-in loans

Securitisation


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Liquidity Management (continued)

Selling debt securities from thesecurities portfolio

Attracting new deposit liabilities

Issuing new shares

Asset Management: Three Goals

Recall that the 2 principal assets on acommercial banks balance sheet are loans

and securities held in the securities portfolio.

Asset management: 3 goals

Generate high returns on loans and securities,subject to:

Controlling risk; and

Ensuring adequate liquidity

Asset Management: Four Tools

Assess borrowers for credit risk (defaultrisk) & impose higher i/r on riskierborrowers (or ration credit)

Purchase securities with appropriaterisk-return tradeoffs

Reduce risk by diversifying assets

Balance need for liquidity against higherreturns from less liquid assets


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Liability Management

Liability management is about acquiringfunds at low cost whilst managing

liquidity risk.

Recall the principal liabilities on acommercial banks balance sheet aredeposits and other borrowed money(interbank borrowings, debt securities orbonds etc).

Liability Management (continued)

Until the global financial crisis (GFC),non-deposit L had increased - inter-bankborrowings, repos, bank-accepted bills,bonds, long-term borrowings; depositsare now increasing.

Deposit L tend to be lower-cost than

non-deposit L but higher liquidity risk

Liability Management (continued)

Deposits account for around 70% of

Australian bank liabilities (higher than inrecent years because of the globalfinancial crisis (GFC)).

Hence, L management requires banks toconsider liquidity risk versus cost offunds.


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Capital Adequacy Management

Bank capital helps prevent bank failure byabsorbing losses.

For a given level of L: If A, then E.Banks holding more capital as a proportion ofassets tend to have lower returns but are atlower risk of failure.

Regulatory requirement (capital adequacyratio): Banks must hold capital equal to orgreater than 8% of risk-weighted A.


Measuring Bank Performance

Return on Assets: net profit after taxes per dollar of assets

ROA =net profit after taxes

assets

Return on Equity: net profit after taxes per dollar of equity capital

ROE =net profit after taxes

equity capital

Relationship between ROA and ROE is expressed by the

Equity Multiplier: the amount of assets per dollar of equity capital

EM =Assets

Equity Capital

net profit after taxes

equity capital

net profit after taxes

assets

assets

equity capital

ROE = ROA EM

Measuring bank performance usinga ROE framework (continued)

ROE is a measure of profitability & is the bestmeasure of overall bank performance.

ROA is a measure of efficiency.

Equity (or leverage) multiplier is inverse ofcapital ratio & thus a measure of risk.

A high equity multiplier indicates a more highlyleveraged bank, lower capital adequacy &higher capital risk.


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Measuring bank performance(continued)

ROE = ROA x EM

=> ROE can because:

Bank becomes more efficient; or

Bank becomes more highly leveraged(orboth).

Measuring bank performance using aROE framework (continued)

Profit Margin (PM) =

measures the ability to pay expenses andgenerate net income from interest andnoninterest income

Asset Utilization (AU)=

measures the amount of interest and

noninterest income generated per dollar oftotal assets

incomeoperatingTotal

incomeNet

assetsTotal

incomeoperatingTotal

Measuring bank performance(continued)

ROA = PM x AU

=> ROA can because:

PM ; or

AU (or both)


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Other Ratios

The net interest margin (NIM) measures the net return on abanks earning assets

The (interest rate) spread measures the differencebetween the average yield on earning assets and averagecost on interest-bearing liabilities

leasesandloansnetsecuritiesinvestment

expenseinterestincomeinterest

assetsearning

incomeinterestnetNIM

sliabilitiebearing-interest

expenseinterest

assetsearning

incomeinterestSpread

Application of ROE Analysis

Comparison of WBS and BOAWBS = Webster Financial Bancorp

BOA = Bank of America

Interest Expense WBS = 18.53%

BOA = 37.16%Operating Income

Profit MarginNet Income

Operating Income PLL WBS = 16.68%

WBS = 4.94% Operating Income BOA = 34.23%

ROA BOA = 9.85%Net Income Noninterest expense WBS = 60.41%

Total Assets Operating Income BOA = 41.36%

WBS = 0.23%

ROE BOA = 0.56% Income Taxes WBS = -0.05%

Net Income Operating Income BOA = 4.37%

Total Equity CapitalWBS = 2.03% Asset Utilization Interest Income WBS = 4.02%

BOA = 4.53% Operating Income Total Assets BOA = 3.83%

Total Assets

Equity Multiplier WBS = 5.08% Noninterest income WBS = 1.07%

Total Assets BOA = 5.67% Total Assets BOA = 1.84%

Total Equity Capital

WBS = 8.99BOA = 8.10

Credit risk

The risk that borrowers or issuers of debtsecurities will default on repayments.

Banks set higher interest rates for higher-riskborrowers but this can adverse incentiveand adverse selection effects probabilityof default.

In this case, rather than further raisinginterest rates, banks engage in creditrationing.


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Managing Credit Risk

Screen loan applicants

Specialise in lending

Monitor and enforce restrictive covenantsDevelop long-term customer relationships

Make loans using loan commitments that requireborrowers to provide continuous information

Require borrowers to have collateral and holdcompensating balances

Ration credit

Interest rate risk

I/r risk is the risk that changes in interestrates will have an adverse impact onthe banks financial performance or networth.

I/r risk has 2 components:

1. Effect on earnings (interest revenueless interest expense) and profits

2. Effect on prices (PV) of A & L (E)


Interest-Rate Risk: Impact onEarnings

If a bank has more rate-sensitive liabilities than assets, a rise ininterest rates will reduce bank profits and a decline in interestrates will raise bank profits

First National Bank

Assets Liabilities

Rate-sensitive assets $20M Rate-sensitive liabilities $50M

Variable-rate and short-term loans Variable-rate CDs

Short-term securities Money market deposit accounts

Fixed-rate assets $80M Fixed-rate liabilities $50M

Reserves Checkable deposits

Long-term loans Savings deposits

Long-term securities Long-term CDs

Equity capital


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Managing i/r risk using gap tables

Divide A & L into those where cash flows if i/r (rate-sensitive A or RSA) &

those where cash flows dont (fixed-rate A & L).

If interest rates change: cash flowsassociated with RSA & RSL also change

Managing i/r risk (continued)

Gap report divides A & L into maturity

buckets

e.g. < 3 months

3-6 months

6-12 months etc

A $ gap (or maturity gap) is calculated for eachtime-bucket.

$ gap = value of interest-sensitive A

lessvalue of interest-sensitive L

Gap tables

Note that several different terms are oftenused to refer to the gap: interest rategap, interest rate repricing gap, maturitygap, interest sensitivity gap.


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Aggressive gap management

If $ gap is positive then:

interest revenues change on RSA morethan interest costs on RSL

Naive rule of (aggressive) gapmanagement:

Naive rule of (aggressive) gapmanagement

If i/r are expected to:

, then structure B/S with +ve gap

, then structure B/S withve gap

Above will lead to net interest income

Defensive gap management

Structure B/S with zero $ gap

=> no in net interest income if i/r or


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I/r risk: Impact on EquityDuration analysis

Duration = weighted average time to

receipt of cash flows.

For a zero coupon bond, there are nocash flows prior to maturity date so:

Duration = Term to maturity

Duration (continued)

For a coupon bond, some cash flows(interest payments) are received beforematurity date so:

Duration < Term to maturity

(We wont worry about calculation of

Duration in this topic. Any examples willgive you duration.)

Copyright 2007 Pearson Addison-Wesley. Allrights reser ved.

Duration (continued)

Duration Analysis:

% market value of security

percentage point interest rate duration in years

Uses the weighted average duration of

a financial institution's assets and of its liabilities

to see how net worth responds to a change in

interest rates


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Example

A = 100

L = 80

E = 20

Weighted DA = 4 yearsWeighted DL = 1 year

Suppose i/r are expected to increase by 1 percentagepoint (100 basis points)

% in PV of A = -1 x 4 = -4 => PV of A = .96 x 100 = 96

% in PV of L = -1 x 1 = -1 => PV of L = .99 x 80 = 79.2

As E = A L, E = 96 -79.2 = 16.8

Summary: the increase in i/r by 1 percentage point afall in E from 20 to 16.8

Managing i/r risk using duration

The bank can reduce the above i/r riskby shortening DA or lengthening DL.

e.g shorten DA by investing in shorter-term securities or by investing insecurities with a higher coupon i/r.

Managing i/r risk using duration(continued)

Both of the above measures ensure

that a higher proportion of the cashflows is received sooner rather thanlater so duration is shorter.

Shorter DA => PV of A wont fall asmuch for a 100 basis point in i/r.


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Off-Balance-Sheet Activities

Loan sales (securitisation)

Generation of fee income

Trading activities and risk managementtechniques (using derivatives)

Next week

Assessing the competitiveness of theAustralian banking sector

lecture 2 banking and the management of financial institutions

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