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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.
Copyright 2006 John Wiley & Sons, Inc.
Provision for loan losses is an expense item that adds to a banks loan loss reserve (a contra-asset account). Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio.
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.
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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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.
Copyright 2006 John Wiley & Sons, Inc.
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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.
Copyright 2006 John Wiley & Sons, Inc.
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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
Copyright 2006 John Wiley & Sons, Inc.
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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 nondeposit borrowing" (e.g. Fed funds, etc.)
LM supplements asset management, but does not supersede it
Copyright 2006 John Wiley & Sons, Inc.
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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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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.
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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.
Copyright 2006 John Wiley & Sons, Inc.
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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
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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.
Copyright 2006 John Wiley & Sons, Inc.
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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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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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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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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.
Copyright 2006 John Wiley & Sons, Inc.
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DG DA ( MVL / MVA ) DL
Where DG = duration gap
DA = duration of assets DL = duration of liabilities MVA = market value of assets MVL = market value of liabilities
Duration GAPs are opposite in sign from maturity GAPs for the same risk exposure.
Copyright 2006 John Wiley & Sons, Inc.
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If interest rates rise More liabilities than assets will lose value, Thus increasing the value of the banks equity
If interest rates fall More liabilities than assets will gain value, Thus reducing the value of the banks 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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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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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
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