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Chapter 6

Banking & the Management of

Financial Institutions

In this Chapter
Because banking system plays a major role in channeling funds
from the savers/lenders to investors/borrowers, it is important
to study:

• How do the financial institutions do the business to maximize

their profit.
• How and why financial institutions make loans.
• How they earn funds and manage their assets and liabilities.

To understand the functioning of the banking system, we study….

In this Chapter

• The Bank Balance Sheet

• Basic Banking

• General Principles of Bank Management including risk


• Risk & Interest Rate Risk

The Bank Balance Sheet

• To understand how banking works we start by looking at the

bank balance sheet.

• The bank balance sheet is a list of the bank assets (what bank
owns) and liabilities (what it owes) where:
Total assets = total liabilities + bank’s capital (net worth).

• Banks make profits by receiving interest rates on their asset

holdings of securities and loans that is higher than the expenses
of their liabilities.

The Bank Balance Sheet –Liabilities

• Liabilities are source of funds a bank uses to purchase assets.
• Banks obtain funds by borrowing and by issuing (selling) other
liabilities such as deposits.

• Liabilities include:
1. Checkable deposits
2. Non-transaction deposits
3. Borrowings
4. Bank capital

The Bank Balance Sheet –Liabilities

1. Checkable deposits include:

– non-interest bearing checking account (demand deposits),

– interest-bearing accounts such as negotiable (NOW) accounts.

– money market deposit accounts (MMDAs).

The Bank Balance Sheet –Liabilities

2. Non-transaction deposits.
– main source of bank funds.
– checks can’t be written on them.
– the interest rates paid are higher than those on checkable deposits.

• They include:
1. Saving accounts
2. Time deposits

The Bank Balance Sheet –Liabilities

3. Borrowings, from:
– the central bank,
– other commercial banks,
– Corporations

4. Bank Capital (net worth)

= total assets - total liabilities
– Bank capital is raised by selling new equity (stock) or
retained earnings.

The Bank Balance Sheet –Assets

• The funds obtained from issuing liabilities are used to acquire

income- earning assets such as securities and loans.
• Banks assets are referred to the uses of funds, and the interest
payments earned on them are what enable banks to make profit.
• Assets include:
– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets

The Bank Balance Sheet –Assets

1. Reserves include:
– what banks keep with central bank,
– currency (papers and coins) kept in the bank vaults

• Reserves are held for two reasons:

– required reserves are required by regulations.
– excess reserves: to meet obligations when funds are

The Bank Balance Sheet –Assets

2. Loans
– Banks make their profits primarily by issuing loans.
– Because of the lack of liquidity and higher default risk, the bank earns its
highest return on loans.

3. Cash items in process of collection

– When a check written on an account at another bank is deposited in your
bank and the funds for this check has not been collected from the other bank,
it is an asset for your bank because it is a claim on another bank for funds
that will be paid within a few days.

The Bank Balance Sheet –Assets

4. Securities
– A bank’s holdings of securities are an important income-earning asset.

5. Deposits at other banks (corresponding banking)

– Small banks hold deposits in larger banks in exchange for a variety of
services, including check collection, foreign exchange transactions, and
help with securities purchase.

6. Other Assets
– The physical capital owned by the banks such as bank buildings, computer,
and other equipments.

Table 1: Balance Sheet of All Commercial Banks (items as a
percentage of the total,

Bank Management

• In general terms, banks make profits by selling liabilities with

one set of characteristics (a particular combination of maturity,
liquidity, risk, size, and return) and using the proceeds to buy
assets with a different set of characteristics.

• This process is often referred to as asset transformation.

Bank Management

For example, a saving deposit held by one person can

provide the funds that enable the bank to make a mortgage
loan to another person.

• The process of transforming assets and providing a set of

services (check clearing, record keeping, credit analysis,
and so forth) is like any other production process in a firm.

• If the bank produces desirable services at low cost and

earns reasonable income on its assets, it earns profits; if
not, the bank suffers losses.

Bank Management

To make the analysis of the operation of a bank more

concrete, let us use a tool called T-account.

• For example, if you have just opened a checking account

with a $100 bill.

• You have a $100 checkable deposit at a bank (the First

Bank), which shows up as a $100 liability on the bank
balance sheet.

• The bank now put your $100 bill into its vault so that the
bank’s assets rise by the $100 increase in vault cash.

Basic Banking: Cash Deposit

Basic Banking: Check Deposit
Alternatively, suppose you had opened the account with a
$100 check written on an account at another bank (the
Second Bank), we would get the same result.

• The initial effect on the T-account of your bank (the First

Bank) is as follows:

Basic Banking: Check Deposit
• If the central bank transfers the $100 of reserves from the Second
Bank to the First Bank and the final balance sheet position of the
two banks are as follows:

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits

• To make a profit, bank rearranges its balance sheet when it

experiences a change in its deposits.

Basic Banking: Making a Profit
• As we know, the bank obliged to keep a certain fraction of its checkable
deposits as required reserves.

• This fraction is called required reserves ratio (RRR).

• If the required reserves ratio is 10%, the First Bank required reserves
have increased by $10.

Basic Banking: Making a Profit
• To make a profit, the bank must put to productive use all or part
of the $90 of excess reserves it has available.

• If the bank decides not to hold any excess reserves but to make
loans instead. The T-account then looks like this:

Basic Banking: Making a Profit

• The bank now is making profit because it holds short term

liabilities such as checkable deposits and uses the proceeds
to buy longer-term assets such as loans with higher interest

•The above discussion has shown you how a bank operates.

Now let us see how a bank manages its assets and liabilities
to earn the highest profit.

Bank Management

• Asset Management

• Liability Management

• Capital Adequacy Management

• Credit Risk Management

• Interest-rate Risk

Asset Management: 3 Goals

• To maximize its profits, a bank must simultaneously seek:

1. The highest possible returns on loans and securities

2. Reduce risk
3. Have adequate liquidity

• To achieve these three goals, banks conduct asset management

in the following 4 ways:

Asset Management: 4 Tools
1. Find borrowers who will pay high interest rates and have low
possibility of defaulting.
– Loans officers engage in screening of the potential borrowers to reduce the
adverse selection process.

2. Purchase securities with high returns and low risk

3. Lower risk by diversifying

– making different types of loans to different types of customers.

4. Balance need for liquidity against increased returns from less liquid
assets (such as loans) to avoid huge costs of deposit outflow.

– banks will hold securities that are more liquid even if they earn somewhat
lower return than other assets.

Liability Management

• Banks aggressively set target goals for their asset growth and
tried to acquire funds by issuing liabilities as they were needed.

• For example, when a bank finds an attractive loan opportunity

it can acquire funds by selling negotiable CDs or through
borrowing from the central bank fund market.

Because of the increased flexibility and importance of liability

management, most banks now manage both sides of the
balance sheet together in an asset-liability management (ALM)

Capital Adequacy Management

• Banks have to make decisions about the amount of capital

they need to hold for three reasons.

(1) Bank capital helps prevents bank failure, a situation in which

the bank cannot satisfy its obligations to pay its depositors and
other creditors.

(2)The amount of capital affects returns for the owners (equity-

holders) of the bank.

(3) A minimum amount of bank capital (bank capital equirements)

is required by regulatory authorities.

Preventing Bank Failure
1. To learn that the bank is managed efficiently, its owners use the
return on assets (ROA) as a measure of bank profitability.
– ROA indicates how much profits are generated on average by each dollar
of assets.
ROA measures how efficiently the bank is run

2. To learn how much the bank is earning on their equity investment,

bank owners measure the return on equity (ROE), the net profit
after taxes per dollar of equity (bank) capital.
ROE measures how well the owners are doing on their investment
The relationship between ROA & ROE is determined by the equity multiplier
(EM) .

• Given the return on assets, the lower the bank capital the higher the returns
for the owners of the bank.

How much Capital a bank should hold?

Choice depends on the state of the economy and levels of

confidence .

Managers must decide how much higher safety they are willing
to trade off against the lower return on equity that comes with
higher capital.

– Unsure times (more possibility of losses on loans) managers

hold more capital to protect the equity holders.

– Good times (confidence on more gains) they reduce the

amount of capital, have a high EM, and thereby increase the

Credit Risk Management

Banks and other financial institutions make loans that must be

paid back in full.

• The possibility of default subjects the financial institutions to

credit risk.

• The economic concepts of adverse selection and moral hazard

provide a framework for understanding the principles that
financial institutions have to follow to reduce credit risk and
make successful loans.

Credit Risk Management

Adverse selection in loan markets occurs because bad credit

risks (the most likely to default on their loans) are the ones who
usually line up for loans.

• Borrowers with very risky investment projects have much to

gain if their projects are successful. However, they are the least
desirable borrowers because of the greater possibility that they
will be unable to pay back their loans.

Credit Risk Management

• Moral hazard exists in loan markets because borrowers

may have incentives to engage in activities that are
undesirable from the lenders point of view. In such
situations, it is more likely that the lender will be subjected
to the hazard of default.

• To be profitable, financial institutions must overcome the

adverse selection and moral hazard problems that make
loan defaults more likely.

Credit Risk: Overcoming Adverse
Selection and Moral Hazard
• The attempts of financial institutions to solve these problems
help explain a number of principles for managing credit risk such
(1) screening and monitoring,
– Screening
– Specialization in lending
– Monitoring and enforcement of restrictive covenants
(2) establishment of long-term customer relationships,
(3) loan commitments,
(4) collateral and compensating balance requirements,
(5) credit rationing.

Credit Risk: Screening and Monitoring

• Adverse selection in loan markets requires that lenders

screen out the bad credit risks from the good ones so that
loans are profitable to them.

• To accomplish effective screening, lenders must collect

reliable information from prospective borrowers.

• Effective screening together with information collection

form an important principle of credit risk management.

Credit Risk: Screening and Monitoring

• The lender uses the information collected from the

various forms the borrowers filled in to evaluate how
good a credit risk you are by calculating your credit
score, a statistical measure derived from your answers
that predicts whether you are likely to have trouble
making your loan payments.

• Deciding on how good a risk you are cannot be entirely

scientific. Personal judgment of the loan officer that is
based on the experience and other factors is also

Credit Risk: Screening and Monitoring

• Once a loan has been made, the borrower has an

incentive to engage in risky activities that make it less likely
that the loan will be paid off.

• To reduce this moral hazard, financial institutions (the

lenders) should write provisions (restrictive covenants) into
loan contracts that restrict borrowers from engaging in risky

Credit Risk: Screening and Monitoring:
Specializing in lending

• Banks often specialize in lending to local firms or to firms

in particular industries.

• To do the screening effectively to avoid bad credit risk, it is

easier for the bank to collect information about local firms
and determine their Credit worthiness than doing the same
thing for firms far away.

• Similarly, by concentrating its lending on firms at specific

industries, the bank becomes more knowledgeable about
these industries and is therefore better able to predict which
firms will be able to make timely payments on their debts.

Credit Risk: Screening and Monitoring: Monitoring &
Enforcement of Restrictive covenants

• To reduce moral hazard, financial institutions (the lenders) should

write provisions (restrictive covenants) into loan contracts that restrict
borrowers from engaging in risky activities.

• By monitoring borrowers activities to see whether they are complying

with the restrictive covenants and by enforcing the covenants if they
are not, lenders can make sure the borrowers are not taking on risks at
their expense.

The need for banks and other financial institutions to engage in

screening and monitoring explains why they spend so much
money on auditing and informationcollecting activities.

Credit Risk: Long-Term Customer Relationship

• Another principle of credit risk management is to establish

a long-term relationship with customers.

• This allows banks and other financial institutions to obtain

information about their borrowers.

• If a prospective borrower has had an account with or loans

from a bank over a long period of time, a loan officer can
look at past activity on the accounts and learn quite a bit
about the borrower.

Credit Risk: Long-Term Customer Relationship

• The long-term customer relationships reduce the costs of

information collection and make it easier to screen out bad
credit risks. LT customer relationships enable banks to deal
with even unanticipated moral hazard contingencies.

• The borrower has the incentive to avoid risky activities that

would upset the bank in order to preserve a long-term
relationship with the bank, which will make it easier to get
future loans at low interest rates. This behavior benefits
both the bank and the customer.

Credit Risk: Loan Commitments

• Banks also create long-term relationships and gather

information by issuing loan commitments to commercial

• A loan commitment is a bank’s commitment for a

specified future period of time to provide a firm with
loans up to a given amount at an interest rate that is tied
to some market interest rate.

• The majority of commercial and industrial loans are

made under the loan commitment arrangement.

Credit Risk: Loan Commitments

The advantage for the firm is that it has a source of credit when
it needs it.

•The advantage for the bank is that the loan commitment

promotes a long-term relationship, which in turn facilitates
information collection.

• A loan commitment agreement is a powerful method for

reducing the bank’s costs for screening and information

Credit Risk: Collateral & Compensating Balances

• Collateral requirements for loans are important credit risk

management tools.

• Collateral is property promised to the lender as compensation if

borrower defaults.

• It lessens the consequences of adverse selection because it

reduces the lender’s losses in the case of loan default. If a
borrower defaults on a loan, the lender can sell the collateral and
use the proceeds to make up for it losses on the loan.

Credit Risk: Collateral & Compensating Balances

• One particular form of collateral required when a bank makes

commercial loans is called compensating balances.

• Compensating balances means that when a firm receives a

loan it must keep a required minimum amount of funds in a
checking account at the bank.

• By requiring the borrower to use a checking account at the

bank, the bank can observe the firm’s check payment practices,
which may yield a great deal of information about the borrower’s
financial condition.

Managing Interest Rate Risk
• Interest-rate risk refers the risk of earnings and returns
that is associated with changes in interest rates.

• Rate-sensitive: when interest rates change frequently

(at least once a year) .

• Fixed-rate: when interest rates remain unchanged for a

long period (over a year)

The conclusion is that 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 increase
bank profits.