Financial Institutions, Markets, and Money, 9 Edition

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Copyright© 2006 John Wiley & Sons, Inc
.


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Power Point Slides for:


Financial Institutions, Markets, and
Money, 9
th

Edition


Authors: Kidwell, Blackwell, Whidbee &



Peterson



Prepared by: Babu G. Baradwaj, Towson University

And

Lanny R. Martindale, Texas A&M University






CHAPTER 14


BANK MANAGEMENT


AND PROFITABILITY

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Bank Earnings: Net Interest Income

Loan interest and fees represent the main source of
bank revenue, followed by interest on investment
securities.


Interest paid on deposits is the largest expense,
followed by interest on other borrowings.


Net interest income is the difference between
gross interest income and gross interest expense.
This margin is relatively stable because the
interest rates banks earn and pay are largely set by
the market.

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Bank Earnings: Provision for Loan Losses

Provision for loan losses is an expense item
that adds to a bank’s loan loss reserve (a
contra
-
asset account).


Banks provide for loan losses in anticipation
of credit quality problems in the loan
portfolio.


Loans are written off against the loan loss
reserve

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Bank Earnings: Non
-
interest income and expense

Noninterest income includes fees and
service charges. This source of revenue has
grown significantly in importance.


Noninterest expense includes personnel,
occupancy, technology, and administration.
These expenses have also grown in recent
years.

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Bank Performance

Trends in profitability can be assessed by
examining
return on average assets


(net income / average total assets) over time.


Another measure of profitability is
return on
average equity
.


In the mid
-

and late
-
1990s, bank profitability
improved significantly.

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Dilemma: Profitability vs. Safety

One way for a bank to increase expected profits is to
take on more risk. However, this can jeopardize
bank safety.


For a bank to survive, it must balance the
demands of three constituencies:



shareholders



depositors



regulators


Each with their own interest in profitability and
safety.

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Solvency and Liquidity

Solvency
:

Maintaining the momentum of a going
concern, attracting customers and financing.


A firm is insolvent when the value of its liabilities
exceeds the value of its assets.

Banks have relatively low capital/asset ratios but
generally high
-
quality assets
.


Liquidity
:

the ability to fund deposit withdrawals,
loan requests, and other promised disbursements
when due.


A bank can be profitable and still fail because of

illiquidity.

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Conflicting Demands

A bank must balance profitability, liquidity, and
solvency.


Bank failure can result from excessive losses on
loans or securities
--

from over
-
aggressive profit
seeking. But a bank that only invests in high
-
quality
assets may not be profitable.


Failure can also occur if a bank cannot meet
liquidity demands. If assets are profitable but
illiquid, the bank also has a problem.


Bank insolvency often leads to bank illiquidity.

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Liquidity Management

Banks rely on both asset sources of liquidity
and liability sources of liquidity to meet the
demands for liquidity.


The demands for liquidity include
accommodating deposit withdrawals,
paying other liabilities as they come due,
and accommodating loan requests.

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Asset Management


classifies bank assets from very liquid/low
profitability to very illiquid/profitable


Primary Reserves

are noninterest bearing, extremely
liquid bank assets


Secondary Reserves

are high
-
quality, short
-
term,
marketable earning assets


Bank Loans are made after absolute liquidity needs
are met


After loan demand is satisfied, funds are allocated to
Income Investments that provide income, reasonable
safety, and some liquidity, if needed

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Asset Management
(cont.)

The bank must manage its assets to provide a
compromise of liquidity and profitability.


Primary and secondary reserve levels relate to:


deposit variability


other sources of liquidity (e.g. Fed funds)


bank regulations
-

permissible areas of investment


risk posture that bank management will assume

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Liability Management

Assumes bank can borrow its liquidity needs at
will in money markets by paying market rate or
better


Liability levels (borrowing) may be quickly
adjusted to loan (asset) needs or deposit
variability


Bank liability liquidity sources include “non
-
deposit borrowing" (e.g. Fed funds, etc.)


LM supplements asset management, but does not
supersede it

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Definition of Bank Capital

Tier 1 capital

or “core” capital includes common
stock, common surplus, retained earnings, non
-
cumulative perpetual preferred stock, minority
interest in consolidated subsidiaries, minus
goodwill and other intangible assets.


Tier 2 capital

or “supplemental” capital includes
cumulative perpetual preferred stock, loan loss
reserves, mandatory convertible debt, and
subordinated notes and debentures
.

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Functions of Bank Capital

Absorb losses on assets (loans) and limit the
risk of insolvency.

Maintain confidence in the banking system.

Provide protection to uninsured depositors
and creditors.

Ultimate source of funds and leverage base
to raise depositor funds.

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Regulatory Capital Standards

As capital requirements have increased, regulators
have also implemented risk
-
based capital
standards.


Capital is measured against
risk
-
weighted assets
.


Risk
-
weighting
is a measure of total assets that
weighs high
-
risk assets more heavily.


The purpose is to require high
-
risk banks to hold
more capital than low
-
risk banks.

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Minimum Capital Requirements

Ratio of
Tier 1 capital

to
risk
-
weighted assets

must be at least 4%


Ratio of Total Capital (
Tier 1
plus
Tier 2
) to
risk
-
weighted assets

must be at least 8%.


Undercapitalized banks receive extra
regulatory scrutiny; regulators may limit
activities, intervene in management, or even
revoke charter.

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Managing Credit Risk

The credit risk of an individual loan concerns the
losses the bank will experience if the borrower
does not repay the loan.

The credit risk of a bank’s loan portfolio concerns
the aggregate credit risk of all the loans in the
bank’s portfolio.

Banks must manage both dimensions effectively
to be successful.

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Managing Credit Risk of Individual Loans

Begins with lending decision (and 5 Cs as
discussed in Chapter 13)


Requires close monitoring to identify
problem loans quickly


The goal is to recover as much as possible
once a problem loan is identified.

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Managing Credit Risk of Loan Portfolio

Internal Credit Risk Ratings

are used to


identify problem loans


determine adequacy of loan loss reserves


price loans


Loan Portfolio Analysis

is used to ensure
that banks are well diversified.

Concentration ratios

measure the percentage
of loans allocated to a given geographic
location, loan type, or business type.

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Measuring Interest Rate Risk: Maturity GAP Analysis

Assets and liabilities which “reprice”
(change interest rate in a specified period of
time) are identified as “rate
-

sensitive”.


A bank's Maturity GAP is computed by
subtracting rate sensitive liabilities (RSL)
from rate sensitive assets (RSA).

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GAP = RSA


RSL; Positive Gap

Positive GAP = RSA > RSL

Net interest income will decline if interest
rates fall

More assets than liabilities reprice
downward if interest rates decline, thus
reducing net interest income

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GAP = RSA


RSL; Negative Gap

Negative GAP = RSA < RSL

Net interest income will decline if interest
rates increase

More liabilities than assets reprice upward
if interest rates increase, thus reducing net
interest income.

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Managing Interest Rate Risk:Duration GAP Analysis

Maturity GAP provides only an approximate rule for
analyzing interest rate risk.


Duration GAP analysis matches cash flows and their
repricing capabilities over a period of time.


The percentage change in the value of a portfolio,
given a change in interest rates, is proportional to the
duration of the portfolio multiplied by the change in
interest rates.

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Managing Interest Rate Risk: Duration GAP Formula

Where

D
G

= duration gap




D
A

= duration of assets




D
L

= duration of liabilities




MV
A

= market value of assets




MV
L

= market value of liabilities



Duration GAPs are opposite in sign from maturity
GAPs for the same risk exposure.

L
A
L
A
G
D
)
MV
/
MV
(
D
D



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Positive Duration GAP

Assets have longer duration than liabilities; bank expects
interest rates to fall


If interest rates rise


More assets than liabilities will lose value,

Thus reducing the value of the bank’s equity



If interest rates fall
-


More assets than liabilities will gain value,


Thus increasing the value of the bank’s equity

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Negative Duration GAP

Liabilities have longer duration than assets; bank expects
interest rates to rise.


If interest rates rise


More liabilities than assets will lose value,

Thus increasing the value of the bank’s equity



If interest rates fall



More liabilities than assets will gain value,


Thus reducing the value of the bank’s equity


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Zero Duration Gap

Bank is immunized against interest rate
risk.


Easier in theory than in practice.


Duration GAP manipulation is a complex
tool, used more by large banks.

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Hedging Interest Rate Risk: Asset
-
Sensitive


Asset
-
sensitive with positive maturity GAP;
negative duration GAP; hurt by falling rates:


Buy financial futures
--
falling rates increase value of
contract, offsetting negative impact of GAP



Buy call options on financial futures


Swap to increase their variable
-
rate cash outflows and
increase their fixed
-
rate (long
-
term) cash inflows


Lengthen repricing of assets; shorten repricing of
liabilities

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Hedging Interest Rate Risk: Liability
-
Sensitive


Liability
-
sensitive with negative maturity GAP;
positive duration GAP;
--
hurt by rising rates:


Sell financial futures
--
increasing rates would increase
value of futures contracts, offsetting the negative
impact of GAP situation


Buy put options on financial futures


Swap long
-
term, fixed
-
rate payments for variable
-
rate
payments


Shorten repricing of assets; lengthen repricing of
liabilities

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