27/02/2012

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 financial institutions (Mishkin) Other reference: Suanders, A. and M. Cornett (2012), Financial Markets and Institutions, 5th edition, McGrawHill Irwin, pp. 391-400. A links to the above reference will be made available on MyUni.

The 3 Rs of Bank Management

Maximise RETURNS to shareholders subject to: an acceptable level of RISK whilst meeting REGULATORY REQUIREMENTS In general, higher returns are associated with higher risks conflicts of interest for stakeholders

27/02/2012

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 emphasis on maintaining strong capital positions

Copyright 2007 Pearson Addison-Wesley. All rights reserved.

9-6

27/02/2012

The bank balance sheet (continued)

Banks must list A & L in order of liquidity from most liquid to least liquid. Liquid A make it easier for banks to respond to unanticipated deposit outflows. A high proportion of liquid L risk of failure (especially through deposit outflows).

Basic BankingMaking a Profit

Asset transformation - selling liabilities with one set of characteristics (liquidity, risk, size & return) and using the proceeds to buy assets with a different set of characteristics. Liquidity and maturity transformation: Banks borrow short (liquid deposits) and lend long (illiquid loans) liquidity risk. Size: Typically, funds from small deposits fund larger loans

Basic BankingMaking a Profit (continued)

Return = Net interest income
Derived from Interest spread (loan rate less deposit rate)

+ fees + income earned from securities portfolio + money earned from off-balance sheet activities

27/02/2012

Banks need to manage:

Liquidity Assets Liabilities Capital Adequacy Credit Risk Interest-rate Risk

Liquidity Risk
The risk that a bank will have insufficient liquid funds to pay depositors or meet other payment commitments as they fall due.

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 deposit outflow
L = A no in E

27/02/2012

Liquidity Management (Shortterm): Shortfall in Reserves

Reserves are a legal requirement (in the sense that balances in ESAs are not allowed to be negative; there is no reserve ratio in Australia) and a potential shortfall must be eliminated.

Liquidity management (continued)

In order to obtain same-day funds, banks can: Borrow from other banks which have positive balances in ESAs in overnight market 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 in financial markets (next-day funds can be obtained this way) Issuing short-term & long-term debt securities Calling-in loans Securitisation

27/02/2012

Liquidity Management (continued)

Selling debt securities from the securities portfolio Attracting new deposit liabilities Issuing new shares

Asset Management: Three Goals

Recall that the 2 principal assets on a commercial 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 (default risk) & impose higher i/r on riskier borrowers (or ration credit) Purchase securities with appropriate risk-return tradeoffs Reduce risk by diversifying assets Balance need for liquidity against higher returns from less liquid assets

27/02/2012

Liability Management
Liability management is about acquiring funds at low cost whilst managing liquidity risk. Recall the principal liabilities on a commercial banks balance sheet are deposits and other borrowed money (interbank borrowings, debt securities or bonds etc).

Liability Management (continued)

Until the global financial crisis (GFC), non-deposit L had increased - inter-bank borrowings, repos, bank-accepted bills, bonds, long-term borrowings; deposits are 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 in recent years because of the global financial crisis (GFC)).

Hence, L management requires banks to consider liquidity risk versus cost of funds.

27/02/2012

Capital Adequacy Management

Bank capital helps prevent bank failure by absorbing losses. For a given level of L: If A, then E. Banks holding more capital as a proportion of assets tend to have lower returns but are at lower risk of failure. Regulatory requirement (capital adequacy ratio): Banks must hold capital equal to or greater than 8% of risk-weighted A.

Measuring Bank Performance

Return on Assets: net profit after taxes per dollar of assets net profit after taxes ROA = assets Return on Equity: net profit after taxes per dollar of equity capital net profit after taxes ROE = equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital Assets EM = Equity Capital net profit after taxes net profit after taxes assets equity capital assets equity capital ROE = ROA EM
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

9-23

Measuring bank performance using a ROE framework (continued)

ROE is a measure of profitability & is the best measure of overall bank performance. ROA is a measure of efficiency. Equity (or leverage) multiplier is inverse of capital ratio & thus a measure of risk. A high equity multiplier indicates a more highly leveraged bank, lower capital adequacy & higher capital risk.

27/02/2012

Measuring bank performance (continued)

ROE = ROA x EM => ROE can because: Bank becomes more efficient; or Bank becomes more highly leveraged(or both).

Measuring bank performance using a ROE framework (continued)

Profit Margin (PM) =
Net income Total operating income

measures the ability to pay expenses and generate net income from interest and noninterest income Total operating income Asset Utilization (AU) = Total assets measures the amount of interest and noninterest income generated per dollar of total assets

Measuring bank performance (continued)

ROA = PM x AU => ROA can because: PM ; or AU (or both)

27/02/2012

Other Ratios
The net interest margin (NIM) measures the net return on a banks earning assets
NIM net interest income interest income interest expense earning assets investment securities net loans and leases

The (interest rate) spread measures the difference between the average yield on earning assets and average cost on interest-bearing liabilities
Spread interest income interest expense earning assets interest - bearing liabilitie s

Application of ROE Analysis

Comparison of WBS and BOA WBS = Webster Financial Bancorp BOA = Bank of America Interest Expense Operating Income Profit Margin Net Income Operating Income WBS = 4.94% BOA = 9.85% WBS = 18.53% BOA = 37.16%

PLL Operating Income

WBS = 16.68% BOA = 34.23%

ROE Net Income Total Equity Capital WBS = 2.03% BOA = 4.53%

ROA Net Income Total Assets WBS = 0.23% BOA = 0.56%

Noninterest expense WBS = 60.41% Operating Income BOA = 41.36% Income Taxes Operating Income Asset Utilization Operating Income Total Assets WBS = 5.08% BOA = 5.67% Interest Income Total Assets Noninterest income Total Assets WBS = -0.05% BOA = 4.37% WBS = 4.02% BOA = 3.83% WBS = 1.07% BOA = 1.84%

Equity Multiplier Total Assets Total Equity Capital WBS = 8.99 BOA = 8.10

Credit risk
The risk that borrowers or issuers of debt securities will default on repayments. Banks set higher interest rates for higher-risk borrowers but this can adverse incentive and adverse selection effects probability of default. In this case, rather than further raising interest rates, banks engage in credit rationing.

10

27/02/2012

Managing Credit Risk

Screen loan applicants Specialise in lending Monitor and enforce restrictive covenants Develop long-term customer relationships Make loans using loan commitments that require borrowers to provide continuous information Require borrowers to have collateral and hold compensating balances Ration credit

Interest rate risk

I/r risk is the risk that changes in interest rates will have an adverse impact on the banks financial performance or net worth.

I/r risk has 2 components: 1. Effect on earnings (interest revenue less interest expense) and profits 2. Effect on prices (PV) of A & L ( E)

Interest-Rate Risk: Impact on Earnings

First National Bank Assets Rate-sensitive assets Variable-rate and short-term loans Short-term securities Fixed-rate assets Reserves Long-term loans Long-term securities Liabilities $20M Rate-sensitive liabilities Variable-rate CDs Money market deposit accounts $80M Fixed-rate liabilities Checkable deposits Savings deposits Long-term CDs Equity capital $50M $50M

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

9-33

11

27/02/2012

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 (fixedrate A & L). If interest rates change: cash flows associated 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 each time-bucket. $ gap = value of interest-sensitive A less value of interest-sensitive L

Gap tables
Note that several different terms are often used to refer to the gap: interest rate gap, interest rate repricing gap, maturity gap, interest sensitivity gap.

12

27/02/2012

Aggressive gap management

If $ gap is positive then: interest revenues change on RSA more than interest costs on RSL Naive rule of (aggressive) gap management:

Naive rule of (aggressive) gap management

If i/r are expected to: , then structure B/S with +ve gap , then structure B/S with ve 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

13

27/02/2012

I/r risk: Impact on Equity Duration analysis

Duration = weighted average time to receipt of cash flows. For a zero coupon bond, there are no cash flows prior to maturity date so:
Duration = Term to maturity

Duration (continued)
For a coupon bond, some cash flows (interest payments) are received before maturity date so: Duration < Term to maturity
(We wont worry about calculation of Duration in this topic. Any examples will give you duration.)

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
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

14

27/02/2012

Example
A = 100 L = 80 E = 20 Weighted DA = 4 years Weighted DL = 1 year Suppose i/r are expected to increase by 1 percentage point (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 a fall in E from 20 to 16.8

Managing i/r risk using duration

The bank can reduce the above i/r risk by shortening DA or lengthening DL. e.g shorten DA by investing in shorterterm securities or by investing in securities 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 cash flows is received sooner rather than later so duration is shorter. Shorter DA => PV of A wont fall as much for a 100 basis point in i/r.

15

27/02/2012

Off-Balance-Sheet Activities
Loan sales (securitisation) Generation of fee income Trading activities and risk management techniques (using derivatives)

Next week
Assessing the competitiveness of the Australian banking sector

16