Financial Markets and Institutions

11th Edition
by Jeff Madura

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 19 Bank Management
Chapter Objectives

■ describe the underlying goal, strategy, and governance

of banks
■ explain how banks manage liquidity
■ explain how banks manage interest rate risk
■ explain how banks manage credit risk
■ explain integrated bank management

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2
 Bank Goals, Strategy, and Governance

Aligning Managerial Compensation with Bank Goals

Banks may implement compensation programs that provide
bonuses to managers that satisfy bank goals.
Bank Strategy
 A bank’s decisions on sources of funds will heavily influence
its interest expenses on the income statement.
 A bank’s asset structure will strongly influence its interest
revenue on the income statement.
 How Financial Markets Facilitate the Bank’s Strategy To
implement their strategy, commercial banks rely heavily on
financial markets. (Exhibit 19.1)

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 Exhibit 19.1 Participation of Commercial Banks in
Financial Markets

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 Bank Goals, Strategy, and Governance

Bank Governance by the Board of Directors

Some of the more important functions of bank directors are to:
 Determine a compensation system for the bank’s executives.
 Ensure proper disclosure of the bank’s financial condition
and performance to investors.
 Oversee growth strategies such as acquisitions.
 Oversee policies for changing the capital structure,
including decisions to raise capital or to engage in stock
repurchases.
 Assess the bank’s performance and ensure that corrective
action is taken if the performance is weak because of poor
management.
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 Bank Goals, Strategy, and Governance

Bank Governance by the Board of Directors (cont.)

 Inside versus Outside Directors
 Board members who are also managers of the bank (i.e.
inside directors) may sometimes face a conflict of interests
because their decisions as board members may affect their
jobs as managers.
 Outside directors (directors who are not managers) are
generally expected to be more effective at overseeing a
bank: they do not face a conflict of interests in serving
shareholders.

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 Bank Goals, Strategy, and Governance

Other Forms of Bank Governance

 Publicly traded banks are subject to potential shareholder
activism.
 The market for corporate control serves as a form of
governance because bank managers recognize that they could
lose their jobs if their bank is acquired.

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 Managing Liquidity

 Banks can experience illiquidity when cash outflows (due to

deposit withdrawals, loans, etc.) exceed cash inflows (new
deposits, loan repayments, etc.).
Management of Liabilities
 They can resolve cash deficiencies by creating additional
liabilities or by selling assets.
 Some assets are more marketable than others, so a bank’s asset
composition can affect its degree of liquidity.

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 Managing Liquidity

Management of Money Market Securities

 Bank can ensure sufficient liquidity by using most of their
funds to purchase short-term Treasury securities or other
money market securities.
 Banks must be concerned about achieving a reasonable return
on their assets, which often conflicts with the liquidity
objective. A proper balance must be maintained.
Management of Loans
 The secondary market for loans has improved the liquidity,
however this liquidity may lessen as economic condition
lessens and demand for selling loans increases.

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 Managing Liquidity

Use of Securitization to Boost Liquidity

 The ability to securitize assets such as automobile and
mortgage loans can enhance a bank’s liquidity.
 The process of securitization involves the sale of assets by the
bank to a trustee, who issues securities that are collateralized
by the assets.
 Collateralized Loan Obligations
 Commercial banks can obtain funds by packaging
their commercial loans with those of other financial
institutions.
 Liquidity Problems
 Typically preceded by other financial problems such
10 as major defaults on their loans.
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 Managing Interest Rate Risk

Net Interest Margin (spread) is the difference between interest

payments received and interest paid:
Interest Revenues - Interest Expenses
Net Interest Margin 
Assets

 During a period of rising interest rates, a bank’s net interest

margin will likely decrease if its liabilities are more rate
sensitive than its assets. (Exhibit 19.2)
 The deposit rates will typically be more sensitive if their
turnover is quicker. (Exhibit 19.3)
 A bank measures the risk and then uses its assessment of
future interest rates to decide whether and how to hedge the
risk.
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 Exhibit 19.2 Impact of Increasing Interest Rates on a Bank’s Net
Interest Margin (if the Bank’s Liabilities are More Sensitive Than Its
Assets)

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 Exhibit 19.3 Impact of Decreasing Interest Rates on a Bank’s Net Interest
Margin (if the Bank’s Liabilities are More Sensitive Than Its Assets)

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 Managing Interest Rate Risk

Methods Used to Assess Interest Rate Risk

 Gap Analysis - Banks can attempt to determine their interest
rate risk by monitoring their gap over time, where: (Exhibit
19.4)
Gap = Rate-sensitive assets – Rate-sensitive liabilities
 An alternative formula is the gap ratio, which is measured
as the volume of rate sensitive assets divided by rate-
sensitive liabilities.
 Many banks classify interest-sensitive assets and liabilities
into various categories based on the timing in which interest
rates are reset .

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 Exhibit 19.4 Interest-Sensitive Assets and Liabilities: Illustration of the
Gap Measured for Various Maturity Ranges for Deacon Bank

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 Managing Interest Rate Risk

Methods Used to Assess Interest Rate Risk

 Duration Measurement
n
Ct (t )

t 1 (1  k )
t
DUR  n
Ct

t 1 (1  k )
t

where :
C  represents the interest or principal payments of the assets
t  the time at which t he payments are provided
k  retired rate of return on the asset

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 Managing Interest Rate Risk

Methods Used to Assess Interest Rate Risk

 The bank can then estimate its duration gap, which is
measured as the difference between the weighted duration of
the bank’s assets and the weighted duration of its liabilities,
adjusted for the firm’s asset size:

DURAS AS DURLIAB LIAB

DURPGAP  
AS AS
 LIAB 
 DURAS- DURLIAB 
 AS 
where
DURAS  weighted average duration of the bank' s assets
DURLIAB weighted average duration of the bank' s liabilitie s
AS  market val ue of the bank' s assets
LIAB  market val ue of the bank' s liabilitie s
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 Managing Interest Rate Risk

Methods Used to Assess Interest Rate Risk

 Regression Analysis
 A bank can assess interest rate risk by determining how
performance has historically been influenced by interest rate
movements.
 This requires that proxies be identified for bank
performance and for prevailing interest rates and that a
model be chosen that can estimate their relationship.
 When a bank uses regression analysis to determine its
sensitivity to interest rate movements, it may combine this
analysis with the value-at-risk (VaR) method to determine
how its market value would change in response to specific
interest rate movements.
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 Managing Interest Rate Risk

Whether to Hedge Interest Rate Risk

 A bank can consider the measurement of its interest rate risk
along with its forecast of interest rate movements to determine
whether it should consider hedging that risk.

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 Managing Interest Rate Risk

Methods Used to Reduce Interest Rate Risk (Exhibit

19.5)
 Maturity matching
 Using-floating rate loans
 Using interest rate futures contracts
 Using interest rate swaps
 Using interest rate caps

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 Exhibit 19.5 Framework for Managing Interest
Rate Risk

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 Managing Interest Rate Risk

Methods Used to Reduce Interest Rate Risk

 Maturity Matching - match each deposit’s maturity with an
asset of the same maturity.
 Using Floating-Rate Loans - Allows banks to support long-
term assets with short-term deposits without overly exposing
themselves to interest rate risk.

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 Managing Interest Rate Risk

Methods Used to Reduce Interest Rate Risk (cont.)

 Using Interest Rate Futures Contracts
 Interest rate futures contracts lock in the price at which
financial instruments can be purchased or sold on a
specified future settlement date.
 Financial futures contracts can reduce the uncertainty about
a bank’s net interest margin. (Exhibit 19.6)
 Using Interest Rate Swaps - an arrangement to exchange
periodic cash flows based on specified interest rates (Exhibits
19.7 & 19.8)

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 Exhibit 19.6 Effect of Financial Futures on the Net Interest Margin of
Banks That Have More Rate-Sensitive Liabilities Than Assets

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 Exhibit 19.7 Illustration of an Interest Rate Swap

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 Exhibit 19.8 Comparison of Denver Bank’s
Spread: Unhedged versus Hedged

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 Managing Interest Rate Risk

Methods Used to Reduce Interest Rate Risk (Cont.)

 Using Interest Rate Caps
 Agreements (for a fee) to receive payments when the interest
rate of a particular security or index rises above a specified
level during a specified time period.
 During periods of rising interest rates, the cap provides
compensation that can offset the reduction in spread during
such periods.
International Interest Rate Risk - When a bank has foreign
currency balances, the strategy of matching the overall interest rate
sensitivity of assets to that of liabilities will not automatically
achieve a low degree of interest rate risk.
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 Managing Credit Risk

Measuring Credit Risk: Banks employ credit analysts who

review the financial information of corporations applying for loans
and evaluate their creditworthiness.
 Determining the Collateral
 When a bank assesses a request for credit, it must decide
whether to require collateral that can back the loan in case
the borrower is unable to make the payments.
 Determining the Loan Rate
 If the bank decides to grant the loan, it can use its
evaluation of the firm to determine the appropriate interest
rate.
 Some loans to high-quality (low-risk) customers are
commonly offered at rates below the prime rate.
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 Managing Credit Risk

Measuring Credit Risk (cont.)

 Measuring Credit Risk of a Bank Portfolio
 Exposure is dependent on types of loans a bank provides.
 Larger proportion of financing credit cards, increases
exposure to credit risk.
 Exposure also changes over time in response to economic
conditions.

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 Managing Credit Risk

Trade-off between Credit Risk and Return

 If a bank wants to minimize credit risk, it can use most of its
funds to purchase Treasury securities.
 A bank concerned with maximizing its return could use most
of its funds to provide credit card and consumer loans.

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 Managing Credit Risk

Trade-off between Credit Risk and Return

 Expected Return and Risk of Subprime Mortgage Loans
 Many commercial banks aggressively funded subprime
mortgage loans in the 2004–2006 period by originating the
mortgages or purchasing mortgage-backed securities that
represented subprime mortgages.
 The banks did not anticipate the credit crisis that occurred in
the 2008–2009 period and that the value of many homes
would decline far below the amount owed on the mortgage.

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 Managing Credit Risk

Reducing Credit Risk

 Industry Diversification of Loans - Banks should diversify
their loans to ensure that their customers are not dependent on
a common source of income.
 International Diversification of Loans - Many banks reduce
their exposure to U.S. economic conditions by diversifying
their loan portfolio internationally.

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 Managing Credit Risk

Reducing Credit Risk (cont.)

 Selling Loans - Banks can eliminate loans that are causing
excessive risk to their loan portfolios by selling them in the
secondary market.
 Revising the Loan Portfolio in Response to Economic
Conditions – banks continually assess both the overall
composition of their loan portfolios and the economic
environment.

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 Managing Market Risk

 Market risk results from changes in the value of securities due

to changes in financial market conditions such as interest rate
movements, exchange rate movements, and equity prices.
 As banks pursue new services related to the trading of
securities, they have become much more susceptible to market
risk.
 The increase in banks’ exposure to market risk is also
attributed to their increased participation in the trading of
derivative contracts.

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 Managing Market Risk

Measuring Market Risk

Banks commonly measure their exposure to market risk by
applying the value-at-risk (VaR) method, which involves
determining the largest possible loss that would occur as a
result of changes in market prices based on a specified percent
confidence level.
 Bank Revisions of Market Risk Measurements - Banks
continually revise their estimate of market risk in response to
changes in their investment and credit positions and to changes
in market conditions.
 Relationship between a Bank’s Market Risk and Interest
Rate Risk - Partially dependent on its exposure to interest rate
risk.
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 Managing Market Risk

Methods Used to Reduce Market Risk

 Could reduce the amount of transactions in which it serves as
guarantor for its clients or reduce the bank’s investment in
foreign debt securities that are subject to adverse events in a
specific region.
 Could attempt to take some trading positions to offset some of
its exposure to market risk.
 Could sell some of its securities that are heavily exposed to
market risk.

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 Integrated Bank Management

Application
 Exhibits 19.9, 19.10, & 19.11.
 Could attempt to take some trading positions to offset some of
its exposure to market risk.

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 Exhibit 19.9 Balance Sheet of Atlanta Bank (in
Millions of Dollars)

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 Exhibit 19.10 Comparative Balance Sheet of
Atlanta Bank

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 Exhibit 19.11 Evaluation of Atlanta Bank Based on
its Balance Sheet

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 Integrated Bank Management

Application (cont.)
 Management of Bank Capital
 The return to shareholders is the return on equity (ROE):
Net profit after taxe s
ROE 
Equity
ROE  Return on assets (ROA)  Leverage Measure
Net profit after taxe s Net profit after taxe s Assets
 
Equity Assets Equity

 The ratio (assets / equity) is called the leverage measure

because leverage reflects the volume of assets a firm
supports with equity.
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 Managing Risk of International Operations

Exchange Rate Risk

 When a bank providing a loan requires that the borrower repay
in the currency denominating the loan, it may be able to avoid
exchange rate risk.

Settlement Risk
 International banks that engage in large currency transactions
are exposed not only to exchange rate risk as a result of their
different currency positions but also to settlement risk, or the
risk of a loss due to settling their transactions.

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 SUMMARY

 The underlying goal of bank management is to maximize the

wealth of the bank’s shareholders, which implies maximizing
the price of the bank’s stock (if the bank is publicly traded). A
bank’s board of directors needs to monitor bank managers to
ensure that managerial decisions are intended to serve
shareholders.
 Banks manage liquidity by maintaining some liquid assets such
as short-term securities and ensuring easy access to funds
(through the federal funds market).

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 SUMMARY (Cont.)

 Banks measure their sensitivity to interest rate movements so

that they can assess their exposure to interest rate risk. Common
methods of measuring interest rate risk include gap analysis,
duration analysis, and measuring the sensitivity of earnings (or
stock returns) to interest rate movements.
 Banks can reduce their interest rate risk by matching the
maturities of their assets and liabilities or by using floating-rate
loans to create more rate sensitivity in their assets.
Alternatively, they could sell financial futures contracts or
engage in a swap of fixed-rate payments for floating-rate
payments.

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 SUMMARY (Cont.)

 Banks manage credit risk by carefully assessing the borrowers

who apply for loans and by limiting the amount of funds they
allocate toward risky loans (such as credit card loans). They
also diversify their loans across borrowers of different regions
and industries so that the loan portfolio is not overly susceptible
to financial problems in any single region or industry.
 An evaluation of a bank includes assessment of its exposure to
interest rate movements and to credit risk. This assessment can
be used along with a forecast of interest rates and economic
conditions to forecast the bank’s future performance.

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