Money and Banking Chapter 9 Bank Management

Chapter Bank Management CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Explain what a balance sheet and a 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 sheet activities and explain their importance . URL books 183

The Balance Sheet LEARNING OBJECTIVE . What is a balance sheet and what are the major types of bank assets and liabilities ?

Thus far , we ve studied financial markets and institutions from feet . We re ready to dive down to the deck and learn how banks and other intermediaries are actually managed . We start with the balance sheet , a statement that takes a snapshot of what a company owns ( assets ) and owes ( liabilities ) at a given moment . The key equation here is a simple one ASSETS ( aka uses ) LIABILITIES ( aka sources ) EQUITY ( aka net worth or capital ) Figure Bank assets ana URL books 184

Figure Assets and liabilities of commercial banks , March , 2007 URL books ' 185 Figure Bank assets and liabilities lists and describes the major types of bank assets and liabilities , and Figure Assets and liabilities of commercial banks , March , 2007 shows the combined balance sheet of all commercial banks on March , 2007 . Stop and Think Box ' 186

In the half of the nineteenth century , bank reserves in the United States consisted solely of bodied specie ( gold or silver ) coins . Banks pledged to pay specie for both their notes and deposits immediately upon demand . The government did not mandate minimum reserve ratios . What level of reserves do you think those banks kept ?

Higher or lower than today required reserves ?

Why ?

With some notorious exceptions known as wildcat banks , which were basically scams , banks kept reserves in the range of 20 to 30 percent , much higher than today required reserves . They did so for several reasons . First , unlike today , there was no fast , easy , cheap way for banks to borrow from the government or other banks . They occasionally did so , but getting what was needed in time was far from assured . So basically borrowing was closed to them . Banks in major cities like Boston , New York , and Philadelphia could keep secondary reserves , but before the advent of the telegraph , banks in the hinterland could not be certain that they could sell the volume of bonds they needed to into thin local markets . In those areas , which included most banks ( by number ) secondary reserves were of little use . And the potential for large net was higher than it is today because early bankers sometimes collected the liabilities of rival banks , then presented them all at once in the hopes of catching the other guy with inadequate specie reserves . Also , runs by depositors were much more frequent then . There was only one thing for a prudent early banker to do keep his or her vaults brimming with coins . KEY TAKEAWAYS A balance sheet is a financial statement that lists what a company owns ( its assets or uses of funds ) and what it owes ( its liabilities or sources of funds ) Major bank assets include reserves , secondary reserves , loans , and other assets . Major bank liabilities include deposits , and shareholder equity . URL books 187

Assets , Liabilities , and LEARNING OBJECTIVES . In five words , what do banks do ?

Without a word limitation , how would you describe what functions they fulfill ?

As Figure Bank assets and liabilities and Figure Assets and liabilities of commercial banks , March , 2007 show , 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 and other assets , including buildings , computer systems , and other physical stuff . Each of those assets plays an important role in the banks overall business strategy . A bank physical assets are needed to conduct its business , whether it be a traditional bank , a full commerce bank ( there are servers and a headquarters someplace ) or a hybrid institution . Reserves allow banks to pay their transaction deposits and other liabilities . In many countries , regulators mandate a minimum level of reserves , called required reserves . When banks hold more than the reserve requirement , the extra reserves are called excess reserves . Because reserves pay no interest , American bankers generally keep excess reserves to a minimum , preferring instead to hold secondary reserves like Treasuries and other safe , liquid , securities . Banks asset is , of course , their loans . They derive most of their income from loans , so they must be very careful who they lend to and on what terms . Banks lend to other banks via the federal funds market , but also in the process of clearing checks , which are called cash items in process of Most of their loans , however , go to . Some loans are , but many are backed by real estate ( in which case the loans are called mortgages ) accounts receivable ( factorage ) or securities ( call loans ) Stop and Think Box Savings banks , a type of bank that issues only savings deposits , and life insurance companies hold significantly fewer reserves than commercial banks do . Why ?

Savings banks and life insurance companies do not suffer large net very often . People do draw down their savings by withdrawing money from their savings accounts , cashing in their life insurance , or URL books 188 taking out policy loans , but remember that one of the advantages of relatively large intermediaries is that they can often meet from . In other words , savings banks and life insurance companies can usually pay customer A withdrawal ( policy loan or surrender ) from customer deposit ( premium payment ) Therefore , they have no need to carry large reserves , which are expensive in terms of opportunity costs . Where do banks get the wherewithal to purchase those assets ?

The side of the balance sheet lists a bank liabilities or the sources of its funds . Transaction deposits include negotiable order of withdrawal accounts ( NOW ) and money market deposit accounts ( in addition to good old checkable deposits . Banks like transaction deposits because they can avoid paying much , if any , interest on them . Some depositors the liquidity that transaction accounts provide so convenient they even pay for the privilege of keeping their money in the bank via various fees , of which more anon . Banks justify the fees by pointing out that it is costly to keep the books , transfer money , and maintain sufficient cash reserves to meet withdrawals . The administrative costs of deposits are lower so banks pay interest for those funds . deposits range from the traditional passbook savings account to negotiable of deposit ( with denominations greater than . Checks can not be drawn on passbook savings accounts , but depositors can withdraw from or add to the account at will . Because they are more liquid , they pay lower rates of interest than time deposits ( aka of deposit ) which impose stiff penalties for early withdrawals . Banks also borrow outright from other banks overnight via what is called , strangely , the federal funds market , and directly from the Federal Reserve via discount loans ( aka advances ) They can also borrow from corporations , including their parent companies if they are part of holding company . That leaves only bank net worth , the between the value ofa bank assets and its liabilities . Equity originally comes from stockholders when they pay for shares in the banks initial public offering ( or direct public offering ( Later , it comes mostly from retained earnings , but sometimes banks make a seasoned offering of additional stock . Regulators watch bank capital closely because , as we learned in Chapter Financial Structure , Transaction Costs , and Asymmetric Information , the more equity a bank has , the less likely it is that it will fail . Today , having learned URL books 189

this lesson the hard way , US . regulators will close a bank down well before its equity reaches zero . Provided , that is , they catch it . Even banks can fail very quickly , especially if they trade in the derivatives market , of which more below . At the broadest level , banks and other financial intermediaries engage in asset transformation . In other words , they sell liabilities with certain liquidity , risk , return , and denominational characteristics and use those to buy assets with a set of characteristics . Intermediaries link investors ( purchasers of banks liabilities ) to entrepreneurs ( sellers of banks assets ) in a more sophisticated way than mere market facilitators like and bankers do ( see Chapter Financial Structure , Transaction Costs , and Asymmetric Information ) More , banks ( aka depository institutions ) turn deposits into loans . In other words , they borrow short and lend long . This , we see , makes bank management tricky business indeed . Other intermediaries transform assets in other ways . Finance companies borrow long and lend short , rendering their management much easier than that of a bank . Life insurance companies sell contracts ( called policies ) that pay off when or if ( during the policy period of a term policy ) the insured party dies . Property and casualty companies sell policies that pay if some exigency , like an automobile crash , occurs during the policy period . The liabilities of insurance companies are said to be contingent because they come due if an event happens rather than after a period of time . Asset transformation and balance sheets provide us with only a snapshot view of a intermediary business . That useful , but , of course , intermediaries , like banks , are dynamic places where changes constantly easiest way to analyze that dynamism is via , balance sheets that list only changes in liabilities and assets . By the way , they are called accounts because they look like a Sort of . Note in the below the horizontal and vertical rules that cross each other , sort of like a Suppose somebody deposits in cash in a checking account . The for the bank accepting the deposit would be the following Some Bunk URL books 190

Sonic an Assets Liabilities Reserves Transaction deposits If another person deposits in her checking account in Some Bank a check for drawn on Another Bank , the initial for that transaction would be the following Sonic Bunk Assets Liabilities Cash in collection . 19 Transaction deposits . 19 Once collected in a few days , the for Some Bank would be the following Sonic Assets Liabilities Cash in collection Reserves The for Another Bank would be the following an Assets Liabilities Reserves ( Transaction deposits ( Gain some practice using by completing the exercises . EXERCISES Write out the for the following transactions . Larry closes his account with Bank , spends of that money on consumption goods , then places the rest in Bank . Suppose regulators tell Bank that it needs to hold only percent of those transaction deposits in . Bank decides that it needs to hold no excess reserves but needs to bolster its secondary reserves . A depositor in bank decides to move from her checking account to a in Bank . URL books 191

. Bank sells of Treasuries and uses the proceeds to fund two mortgages and the purchase of of municipal bonds . Note This is net . The bank merely moved from one type of security to another . KEY TAKEAWAYS In five words , banks lend ( long ( and ( borrow ( short ( Like other financial intermediaries , banks are in the business of transforming assets , of issuing liabilities with one set of characteristics to investors and of buying the liabilities of borrowers with another set of characteristics . Generally , banks issue liabilities but buy assets . This raises specific types of management problems that bankers must be proficient at solving if they are to succeed . If that check were drawn on Some Bank , there would be no need for a because the bank would merely subtract the amount from the account of the payer , or in other words , the check maker , and add it to the account of the payee or check recipient . URL books 192

Bank Management Principles LEARNING OBJECTIVE . What are the major problems facing bank managers and why is bank management closely regulated ?

Bankers must manage their assets and liabilities to ensure three conditions . Their bank has enough reserves on hand to payfor any deposit ( net decreases in deposits ) but not so many as to render the bank . This tricky is called liquidity management . Their bank earns . To do so , the bank must own a diverse portfolio of remunerative assets . This is known as asset management . It must also obtain its funds as cheaply as possible , which is known as liability management . Their bank has net worth or equity capital to maintain a cushion against bankruptcy or regulatory attention but not so much that the bank is . This second tricky is called capital adequacy management . In their quest to earn profits and manage liquidity and capital , banks face two major risks credit risk , the risk of borrowers defaulting on the loans and securities it owns , and interest rate risk , the risk that interest rate changes will decrease the returns on its assets or increase the cost of its liabilities . The panic of 2008 reminded bankers that they also can face liability and capital adequacy risks if financial markets become less liquid or seize up completely ( Stop and Think Box What wrong with the following bank balance sheet ?

Film Cit ) Shoot June 31 . 200 ) I ) Liabilities Assets Reserves 10 Transaction deposits 20 Security 10 deposits 50 70 ( 15 ) Other assets Capitol worth 10 Totals 100 100 URL books ' 193 There are only 30 days in June . It can be in thousands of dollars because this bank would be well below efficient minimum scale . The labels are reversed but the entries are okay . By convention , assets go on the left and liabilities on the right . can be but not negative . Only equity capital can be negative . What is Capitol worth ?

A does not equal Indeed , the columns do not sum to the purported It is Loans ( not ) and Securities ( not Security ) Thankfully , assets is not abbreviated ! Let turn first to liquidity management . Big Apple Bank has the following balance sheet Assets Liabilities Reserves 10 Transaction deposits 30 Securities 10 deposits 55 Loans 70 Other assets 10 Capital 10 Totals 100 100 Suppose the bank then experiences a net transaction deposit of million . The banks balance sheet ( we could also use here but we won ) is now like this Assets Liabilities Reserves Transaction deposits 25 Securities 10 deposits 55 Loans 70 Other assets 10 Capital 10 Totals 95 95 The banks reserve ratio ( deposits ) has dropped from to . That still pretty good . But if another million out of the bank on net ( maybe 10 million is deposited but 15 million is withdrawn ) the balance sheet will look like this Assets Liabilities Reserves Transaction deposits 20 Securities 10 deposits 55 books 194

Big Apple Slicer ( Loans 70 Other assets 10 Capital 10 Totals 90 90 The banks reserve ratio now drops to . That bound to be below the reserve ratio required by regulators and in any event is very dangerous or the bank . What to do ?

To manage this liquidity problem , bankers will increase reserves by the least expensive means at their disposal . That almost certainly will not entail selling off real estate or calling in or selling loans . Real estate takes a long time to sell , but , more importantly , the bank needs it to conduct business ! Calling in loans ( not renewing them as they come due and literally calling in any that happen to have a call feature ) will likely antagonize borrowers . Loans can also be sold to other lenders , but they may not pay much for them because adverse selection is high . Banks that sell loans have an incentive to sell off the ones to the worst borrowers . If a bank reduces that risk by promising to buy back any loans that default , that bank risks losing the borrower future business . The bank might be willing to sell its securities , which are also called secondary reserves for a reason . If the bankers decide that is the best path , the balance sheet will look like this Big Apple Slicer ( Assets Liabilities Reserves 10 Transaction deposits 20 Securities deposits 55 Loans 70 Other assets 10 Capital 10 Totals 90 90 The reserve ratio is now , which is high but prudent if the banks managers believe that more net deposit are likely . Excess reserves are insurance against further , but keeping them is costly because the bank is no longer earning interest on the 10 million of securities it sold . Of course , the bank could sell just , say , or million of securities if it thought the net deposit was likely to stop . URL books ' 195

The bankers might also decide to try to lure depositors back by offering a higher rate of interest , lower fees , better service . That might take some time , though , so in the meantime they might decide to borrow million from the Fed or from other banks in the federal funds market . In that case , the bank balance sheet would change to the following Big Shoot ( Assets Liabilities Reserves Transaction deposits 20 Securities 10 deposits 55 Loans 70 10 Other assets 10 Capital 10 Totals 95 95 Notice how changes in liabilities drive the bank size , which shrank from 100 to 90 million when deposits shrank , which stayed the same size when assets were manipulated , but which grew when million was borrowed . That is why a bank liabilities are sometimes called its sources of Now try your hand at liquidity management in the exercises . EXERCISES Manage the liquidity of the Bank given the following scenarios . The legal reserve requirement is percent . Use this initial balance sheet to answer each question ' Shoot ( Assets Liabilities Reserves Transaction deposits 100 Securities 10 deposits 250 Loans 385 50 Other assets 100 Capital 100 Totals 500 500 . Deposits out . Deposit . Deposit lows of and of . ows of 42 and of . ows of 37 and of . URL books 196

. A large depositor says that she needs million from her checking account , but just for two days . Otherwise , net are expected to be about zero . Net transaction deposit are zero , but there is a million net outflow from deposits . Asset management entails the usual risk and return . Bankers want to make safe , rate loans but , of course , few of those are to be found . So they must choose between giving up some interest or suffering higher default rates . Bankers must also be careful to diversify , to make loans to a variety of different types of borrowers , preferably in different geographic regions . That is because sometimes entire sectors or regions go bust and the bank will too if most of its loans were made in a depressed region or to the struggling group . Finally , bankers must bear in mind that they need some secondary reserves , some assets that can be quickly and cheaply sold to bolster reserves if need be . Today , bankers decisions about how many excess and secondary reserves to hold is partly a function of their ability to manage their liabilities . Historically , bankers did not try to manage their liabilities . They took deposit levels as given and worked from there . Since the , however , banks , especially big ones in New York , Chicago , and San Francisco ( the money centers ) began to actively manage their liabilities by actively trying to attract deposits selling large denomination to institutional investors borrowing from other banks in the overnight federal funds market . Recent regulatory reforms ( discussed in greater detail in Chapter 11 The Economics of Financial Regulation ) have made it easier for banks to actively manage their liabilities . In typical times today , if a bank has a profitable loan opportunity , it will not hesitate to raise the funds by borrowing from another bank , attracting deposits with higher interest rates , or selling an . That leaves us with capital adequacy management . Like reserves , banks would hold capital without regulatory prodding because equity or net worth buffers banks ( and other companies ) from temporary losses , and setbacks . However , like reserves , capital is costly . The more there is of it , holding profits constant , the less each dollar of it earns . So capital , like reserves , is now subject to minimums called capital requirements . URL books 197

Consider the balance sheet of Safety Bank Assets Liabilities Reserves 81 Transaction deposits 10 Securities deposits 75 Loans Other assets Capital 10 Totals 100 100 If billion of its loans went bad and had to be completely written off , Safety Bank would still be in operation Assets Liabilities Reserves 81 Transaction deposits 10 Securities deposits 75 Loans Other assets Capital Totals 95 95 Now , consider Shaky Bank Assets Liabilities Reserves 81 Transaction deposits 10 Securities deposits 80 Loans Other assets Capital Totals 100 100 If billion of its loans go bad , so too does Shaky . Assets Liabilities Reserves 81 Transaction deposits 10 Securities deposits 80 URL books 198

Bunk ( Billions ) Loans 85 Other assets Capital ( Totals 95 95 You do need to be a certified public accountant ( to know that red numbers and negative signs are not good news . Shaky Bank is a now a new kind of bank , bankrupt . Why would a banker manage capital like Shaky Bank instead of like Safety Bank ?

In a word , profitability . There are two major ways of measuring profitability return on assets ( and return on equity ( ROE ) net ROE net ( capital , net worth ) Suppose that , before the loan debacle , both Safety and Shaky Bank had 10 billion in profits . The of both would be Shaky Bank ROE , what shareholders care about most , would leave Safety Bank in the dust because Shaky Bank is more highly leveraged ( more assets per dollar ) Shaky Bank ROE 10 Safety Bank ROE This , of course , is nothing more than the standard applied to banking . Regulators in many countries have it prudent to mandate capital adequacy standards to ensure that some bankers are not taking on high levels of risk in the pursuit . Bankers manage bank capital in several ways a . By buying ( selling ) their own bank stock in the open market . That reduces ( increases ) the number of shares outstanding , raising ( decreasing ) capital and ROE , By paying ( withholding ) dividends , which decreases ( increases ) capital , increasing ( decreasing ) ROE , all else equal URL books ' 199

By increasing ( decreasing ) the bank assets , which , with capital held constant , increases ( decreases ) ROE These same concepts and , liability , capital , and liquidity management , and and to other types of intermediaries as well , though the details , of course , differ . KEY TAKEAWAYS Bankers must manage their bank liquidity ( reserves , for regulatory reasons and to conduct business effectively ) capital ( for regulatory reasons and to buffer against negative shocks ) assets , and liabilities . There is an opportunity cost to holding reserves , which pay no interest , and capital , which must share the profits of the business . Left to their own judgment , bankers would hold reserves and capital , but they might not hold enough to prevent bank failures at what the government or a country citizens deem an acceptably low rate . That induces government regulators to create and monitor minimum requirements . URL books 200

Credit Risk LEARNING OBJECTIVE . What is credit risk and how do bankers manage it ?

As noted above , loans are banks bread and butter . No matter how good bankers are at asset , liability , and capital adequacy management , they will ifthey can not manage credit risk . Keeping defaults to a minimum requires bankers to be keen students of asymmetric information ( adverse selection and moral hazard ) and techniques for reducing them , Bankers and insurers , like computer folks , know about in , garbage out . If they lend to or insure risky people and companies , they are going to suffer , So they carefully screen applicants for loans and insurance . In other words , to reduce asymmetric information , intermediaries create information about them . One way they do so is to ask applicants a wide variety of questions . Financial intermediaries use the application only as a starting point . Because risky applicants might stretch the truth or even outright lie on the application , intermediaries typically do two things ( make the application a binding part contract , and ( verify the information with disinterested third parties . The allows them to void contracts if applications are fraudulent . If someone applied for life insurance but did not disclose that he or she was suffering from a terminal disease , the life insurance company would not pay , though it might return any premiums . That may sound cruel to you , but it isn . In the process of protecting its , the insurance company is also protecting its . In other situations , the intermediary might not catch a falsehood in an application until it is too late , so it also verifies important information by calling employers ( Is John Doe really the Supreme Commander of Corporation ?

conducting medical examinations ( Is Jane Smith really in perfect health despite being ' tall and weighing 567 pounds ?

hiring appraisers ( Is a , house on the wrong side of the tracks really worth million ?

and so forth . Financial intermediaries can also buy credit reports from report providers like , or Trans Union . Similarly , insurance companies regularly share information with each other so that risky applicants can take advantage of them easily . URL books 201

To help improve their screening acumen , intermediaries specialize . By making loans to only one or a few types of borrowers , by insuring automobiles in a handful of states , by insuring farms but not factories , intermediaries get very good at discerning risky applicants from the rest . Specialization also helps to keep monitoring costs to a minimum . Remember that , to reduce moral hazard ( asymmetric information ) intermediaries have to pay attention to what borrowers and people who are insured do . By specializing , intermediaries know what sort of restrictive covenants ( aka loan covenants ) to build into their contracts . Loan covenants include the frequency of providing financial reports , the types of information to be provided in said reports , working capital requirements , permission for onsite inspections , limitations on account withdrawals , and call options if business performance deteriorates as measured by business ratios . Insurance companies also build covenants into their contracts . You can turn your home into a brothel , it turns out , and retain your insurance coverage . To reduce moral hazard , insurers also investigate claims that seem . If you wrap your car around a tree the day after insuring it or increasing your coverage , the insurer claims adjuster is probably going to take a very close look at the alleged accident . Like everything else in life , however , specialization has its costs . Some companies overspecialize , hurting their asset management by making too many loans or issuing too many policies in one place or to one group . While credit risks decrease due to specialization , systemic risk to assets increases , requiring bankers to make decisions regarding how much to specialize . Forging relationships with customers can also intermediaries to manage their credit risks . Bankers , for instance , can lend with better assurance if they can study the checking and savings accounts of applicants over a period of years or decades . Repayment records of applicants who had previously obtained loans can be checked easily and cheaply . Moreover , the expectation ( there that word again ) of a relationship changes the borrower calculations . The game , if you will , is no longer a prisoner dilemma , where it is in both parties interest to defect , but rather a repeated game , where the optimal strategy is one of tit for until the other guy defects . One way that lenders create relationships with businesses is by providing loan commitments , promises to lend at interest ( or plus some market rate ) for years . Such arrangements are so URL books 5019 ) 202

for both lenders and borrowers that most commercial loans are in fact loan commitments . Such commitments are sometimes called lines of credit , particularly when extended to consumers . Bankers also often insist on pledged by the borrower for repayment of a loan . When those assets are cash left in the bank , the collateral is called compensating or compensatory balances . Another powerful tool to combat asymmetric information is credit rationing , to make a loan at any interest rate ( to reduce adverse selection ) or lending less than the sum requested ( to reduce moral hazard ) Insurers also engage in both types of rationing , and for the same reasons people willing to pay high rates or premiums must be risky , and the more that is lent or insured ( the higher the likelihood that the customer will abscond , cheat , or set , as the case may be . As the world learned to its chagrin in , banks and other lenders are not perfect . Sometimes , under competitive pressure , they lend to borrowers they should not have . Sometimes , individual bankers profit handsomely by lending to very risky borrowers , even though their actions endanger their banks very existence . Other times , external political or societal pressures induce bankers to make loans they normally wouldn . Such excesses are always reversed eventually because the lenders suffer from high levels of nonperforming loans . Stop and Think Box In the first quarter of 2007 , banks and other intermediaries specializing in originating home mortgages ( called mortgage companies ) experienced a major setback in the subprime market , the segment of the market that caters to borrowers , because default rates soared much higher than expected . Losses were so extensive that many people feared , correctly as it turned out , that they could trigger a crisis . To stave off such a potentially dangerous outcome , why didn the government immediately intervene by guaranteeing the subprime mortgages ?

The government must be careful to try to support the system without giving succor to those who have screwed up . Directly bailing out the subprime lenders by guaranteeing mortgage payments would cause moral hazard to skyrocket , it realized . Borrowers might be more likely to default by rationalizing that the crime is a victimless one ( though , in fact , all taxpayers would that there is no such URL books 203

thing as a free lunch in economics ) Lenders would learn that they can make crazy loans to anyone because good ol Uncle Sam will cushion , or even prevent , their fall . KEY TAKEAWAYS Credit risk is the chance that a borrower will default on a loan by not fully meeting stipulated payments on time . Bankers manage credit risk by screening applicants ( taking applications and verifying the information they contain ) monitoring loan recipients , requiring collateral like real estate and compensatory balances , and including a variety of restrictive covenants in loans . They also manage credit risk by trading off between the costs and benefits of specialization and portfolio diversification . URL books 204

Risk LEARNING OBJECTIVE . What is interest rate risk and how do bankers manage it ?

Financial intermediaries can also be brought low by changes in interest rates . Consider the situation of Some Bank ( Billions 51 ) Assets Liabilities assets like variable rate and liabilities like variable loans and securities 10 rate and 20 assets like reserves , loans and securities liabilities like checkable deposits , 50 , equity capital 40 If interest rates increase , Some Bank gross , the difference between what it pays for its liabilities and earns on its assets , will decline because the value of its liabilities exceeds that of its assets ( assuming the spread stays the same ) Say , for instance , it today pays percent for its liabilities and receives percent on its assets . That means it is paying 20 billion to earn 10 billion . Not bad work if you can get it . If interest rates increase percent on each side of the balance sheet , Some Bank will be paying 20 billion to earn 10 billion . No there . If rates increase another percent , it will have to pay 20 billion to earn 10 billion , a total loss of billion ( from a billion to a billion loss ) Stop and Think Box was unexpectedly high in the . Given what you learned about the relationship between and nominal interest rates The Economics of Fluctuations , and between interest rates and bank profitability in this chapter , what happened in the 19805 ?

Bank profitability sank to the point that many banks , the infamous savings and loans ( went under . via the Fisher Equation ) caused nominal interest rates to increase , which hurt banks because they were earning low rates on assets ( like bonds ) while having URL books gob ?

205 to pay high rates on their liabilities . Mounting losses induced many bankers to take on added risks , including risks in the derivatives markets . A few restored their banks to , but others destroyed all of their banks capital and then some . Ofcourse , ifthe value ofits assets exceeded that ofits liabilities , the bank would from interest rate increases . It would suffer , though , if interest rates decreased . Imagine Some Bank has 10 billion in interest assets at percent and only billion in interest sensitive liabilities at percent . It is earning 10 billion while paying 05 billion . If interest rates decreased , it might earn only 10 billion while paying billion thus , its gross would decline from billion to billion , a loss of billion . More formally , this type of calculation , called basic gap analysis , is ( A , where , changes in profitability Ar assets liabilities i change in interest rates So , returning to our example , lO 20 ) lO billion , and the example above , billion . Complete the exercise to get comfortable conducting basic gap analysis . EXERCISE Use the basic gap analysis formula to estimate Some Bank loss or gain under the following scenarios . A , Ai URL books 206

Risk Sensitive Assets Risk Sensitive Liabilities Change in Interest Answer , Millions ( Millions ) Millions ) Rates ( 100 100 100 100 200 10 100 200 10 199 200 10 199 200 200 100 10 10 200 100 200 199 10 200 199 1000 10 1000 Now , take a look at Figure Basic gap analysis matrix , which summarizes , in a matrix , what happens to bank when the gap is positive ( Ar ) or negative ( Ar ) when interest rates fall or rise . Basically , bankers want to have more assets than liabilities if they think that interest rates are likely to rise and they want to have more interest liabilities than assets if they think that interest rates are likely to decline . Figure Basic gap analysis matrix URL books ?

207 Of course , not all liabilities and assets have the same , so to assess their interest rate risk exposure bankers usually engage in more sophisticated analyses like the maturity bucket approach , standardized gap analysis , or duration analysis . Duration , also known as Duration , measures the average length of a security stream of payments . In this context , duration is used to estimate the sensitivity ofa ty or a portfolio market value to interest rate changes via this formula A i A percentage change in market value At change in interest ( not , represent as , not . Also note the negative sign . The sign is negative because , as we learned in Chapter Interest Rates , interest rates and prices are inversely related . duration ( years ) So , if interest rates increase percent and the average duration of a bank 100 million of assets is years , the value of those assets will fall approximately , or million . If the value of that banks liabilities ( excluding equity ) is 95 million , and the duration is also years , the value of the liabilities will also fall , 95 million , effectively reducing the bank equity ( million . If the duration of the bank liabilities is only year , then its liabilities will fall or 95 million , and the bank will suffer an even larger loss ( of million . If , on the other hand , the duration of the bank liabilities is 10 years , its liabilities will decrease 10 or 19 million and the bank will from the interest rate rise . A basic interest rate risk reduction strategy when interest rates are expected to fall is to keep the duration of liabilities short and the duration of assets long . That way , the bank continues to earn the old , higher rate on its assets but from the new lower rates on its deposits , and other liabilities . As noted above , borrowing short and lending long is second banks , which tend to thrive when interest rates go down . When interest rates increase , banks would like to keep the duration of assets short and the duration of liabilities long . That way , the bank earns the new , higher rate on its assets and keeps its liabilities locked in at the older , lower rates . But banks can only go so URL books ' 208

far in this direction because it runs against their nature few people want to borrow if the loans are callable and fewer still want checkable deposits ! KEY TAKEAWAYS Interest rate risk is the chance that interest rates may increase , decreasing the value of bank assets . Bankers manage interest rate risk by performing analyses like basic gap analysis , which compares a interest rate assets and liabilities , and duration analysis , which accounts for the fact that bank assets and liabilities have different . Such analyses , combined with interest rate predictions , tell bankers when to increase or decrease their assets or liabilities , and whether to shorten or lengthen the duration of their assets or liabilities . Bankers can also hedge against interest rate risk by trading derivatives , like swaps and futures , and engaging in other activities . and URL books 209

Off the Balance Sheet LEARNING OBJECTIVE . What are activities and why do bankers engage in them ?

To protect themselves against interest rate increases , banks go , engaging in activities that do not appear on their balance sheets . Banks charge customers all sorts , and notjust the little ones that they sometimes slap on retail checking depositors . They also charge fees for loan guarantees , backup lines of credit , and foreign exchange transactions . Banks also now sell some of their loans to investors . Banks usually make about percent when they sell a loan , which can be thought of as their fee for originating the loan , for , in other words , finding and screening the borrower . So , for example , a bank might discount the note of for year at percent . We know from the present value formula that on the day it is made , said loan is worth ( i ) The bank might sell it for and pocket the difference . Such activities are not without risks , however . Loan guarantees can become very costly if the guaranteed party defaults . Similarly , banks often sell loans with a guarantee or stipulation that they will buy them back if the borrower defaults . If they didn do so , as noted above , investors would not pay much for them because they would fear adverse selection , that is , the bank pawning off their worse loans on unsuspecting third parties . Although loans and fees can help keep up bank revenues and profits in the face of rising interest rates , they do not absolve the bank of the necessity of carefully managing its credit risks . Banks ( and other financial intermediaries ) also take positions in derivatives markets , including futures and interest rate swaps . They sometimes use derivatives to hedge their risks that is , they try to earn income should the banks main business a decline if , say , interest rates rise . For example , bankers sell futures contracts on US . Treasuries at the Chicago Board of Trade . If interest rates increase , the price of bonds , we know , will decrease . The bank can then effectively buy bonds in the open market at less than the contract price , make good on the contract , and pocket the difference , helping to offset the damage the interest rate increase will cause the banks balance sheet . URL books 210

Bankers can also hedge their banks interest rate risk by engaging in interest rate swaps . A bank might agree to pay a company a percent on a 100 million notational principle ( or million ) every year for ten years in exchange for the company promise to pay to the bank a market rate like the federal funds rate or London Interbank Offering Rate ( plus percent If the market rate increases from percent ( which initially would entail a wash because plus contractual ) to percent , the company will pay the net due to the bank , on 100 million ) million , which the bank can use to cover the damage to its balance sheet brought about by the higher rates . If interest rates later fall to percent , the bank will have to start paying the company ( on 100 million ) million per year but will well be able to afford it . Banks and intermediaries also sometimes speculate in derivatives and exchange markets , hoping to make a big killing . Of course , with the potential for high returns comes high levels of risk . Several hoary banks have gone bankrupt because they assumed too much risk In some cases , the failures were due to the problem rogue traders bet their jobs , and their banks , and lost . In other cases , traders were mere scapegoats , instructed to behave as they did by the bank managers or owners . In either case , it is to have much sympathy for the bankers , who were either deliberate or incompetent . There are some very basic internal controls that can prevent traders from risking too much of the capital of the banks they trade for , as well as techniques , called value at risk stress testing , that allow bankers to assess their banks derivative risk exposure . KEY TAKEAWAYS activities like fees , loan sales , and derivatives trading help banks to manage their interest rate risk by providing them with income that is not based on assets ( and hence is off the balance sheet ) Derivatives trading can be used to hedge or reduce interest rate risks but can also be used by risky bankers or rogue traders to increase risk to the point of endangering a bank capital cushion and hence its economic existence . URL books 211

This is not to say that these activities are not accounted for . It is illegal or even slimy . These activities will appear on revenue statements , cash flow analyses , etc . They do not , however , appear on the balance sheet , on the list of the bank assets and liabilities . URL books 212

Suggested Reading , and Liability Management Strategy , Trading , Analysis . John Wiley and Sons , 2007 . Jean , and . Asset and Liability Management A Guide to Value Creation and Risk Control . New York Prentice Hall , 2002 . Edward Hidden Financial Risk Understanding . John Wiley and Sons , 2003 . James , and Benton Gup . Commercial Banking The Management of Risk . John Wiley and Sons , 2004 . URL books 213