Week 7 Bank Management Lecture (PDF)

Week 7 Bank management BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Describe a commercial bank’s assets and liabilities. 2. Define bank capital and key measures of bank profits and returns. 3. Identif...

Week 7 Bank management BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Describe a commercial bank’s assets and liabilities. 2. Define bank capital and key measures of bank profits and returns. 3. Identify the type and sources of bank risk and explain how to control them. The University of Sydney Page 2  Introduction – Most people use the word bank to describe a depository institution. – There are depository and non-depository institutions that differ by their primary source of funds - the liability side of their balance sheet. – Depository institutions include – Commercial banks, savings and loans, and credit unions. The University of Sydney Page 3  The Balance Sheet of Commercial Banks – Commercials banks are institutions established to provide banking services to businesses, allowing them to deposit funds safely and to borrow them when necessary. – Total bank assets = Total bank liabilities + Bank capital. – Banks obtain funds from individual depositors and businesses, as well as by borrowing from other financial institutions in financial markets. The University of Sydney Page 4  The Balance Sheet of Commercial Banks – The difference between a bank’s assets and liabilities is the bank’s capital, or net worth. – Net worth is the value of the bank to its owners. – A bank’s profits come from both service fees and from the difference between what it pays for its liabilities and the return it receives on its assets. The University of Sydney Page 5 The University of Sydney Page 6  Bank Capital and Profitability – Net worth is referred to as bank capital, or equity capital. – We can think of capital as the owners’ stake in the bank. – Capital is the cushion banks have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities. – It provides some insurance against insolvency. The University of Sydney Page 7  Bank Capital and Profitability – An important component of bank capital is loan loss reserves: – Loan loss reserves are an amount the bank sets aside to cover potential losses from defaulted loans. – At some point the bank gives up hope a loan will be repaid and it is written off, or erased from the bank’s balance sheet. – At this point, the loan loss reserve is reduced by the amount of the loan that has defaulted. The University of Sydney Page 8  Contra Asset Account Example Suppose I make a loan for $500 today, and I estimate that I will only recover $495. Accounting Entry looks like this: Provision for Loan Loss (Bad Debt Expense) $5 Allowance for Loan & Lease Losses (ALLL-Contra Asset) $5 B/S looks like this: Loans $500 Liabilities $445 ALLL $5 Net Loans $495 Equity $50 When the customer actually fails to pay me $5, the entry is: ALLL $5 Loans $5 And my B/S now Loans $495 Liabilities $445 Charge off $5 of loans looks like this: ALLL $0 Net Loans $495 Equity $50 The University of Sydney Page 9  Contra Asset Account Example Suppose I thought all I would have is a $5 loss, but I lose $10! Start here Loans $500 Liabilities $445 ALLL $5 Net Loans $495 Equity $50 Now $10 go bad. I take what I can out of ALLL but it is not enough, so I have to take the extra out of my equity account: ALLL $5 Equity $5 Loans $10 Charge off $10 of loans B/S will look like this: Loans $490 Liabilities $445 ALLL $0 Net Loans $490 Equity $45 Took a hit by amount of unanticipated loss The University of Sydney Page 10  Bank Capital and Profitability There are several measures of bank profitability. 1. Return on assets (ROA) – ROA is the bank’s net profit left after taxes divided by the bank’s total assets. Net profit after taxes ROA = Total bank assets – It is a measure of how efficiently a particular banks uses its assets. – This is less important to bank owners than the return on their own investment. The University of Sydney Page 11  Bank Capital and Profitability 2. The bank’s return to its owners is measured by the return on equity (ROE). This is the bank’s net profit after taxes divided by the bank’s capital. – ROA and ROE are related to leverage. – One measure of leverage is the ratio of banks assets to bank capital. – Multiplying ROA by this ratio yields ROE. The University of Sydney Page 12  Bank Capital and Profitability Net profit after taxes ROE = Bank Capital Bank Assets Net profit after taxes Bank Assets ROA  =  Bank Capital Total bank assets Bank Capital Net profit after taxes = = ROE Bank capital The University of Sydney Page 13  Bank Capital and Profitability – Prior to the financial crisis of 2007-2009, the typical U.S. bank had a ROA of about 1.3%. – For large banks, the ROE tends to be higher than for small banks, suggesting greater leverage, a riskier mix of assets, or the existence of significant economies to scale in banking. – The poor performance during the crisis and moderate returns after, suggests their high returns were at least partly due to more leverage or a riskier mix of assets. The University of Sydney Page 14  Bank Capital and Profitability 3. The final measure of bank profitability is net interest income. – This is related to the fact that banks pay interest on their liabilities and receive interest on their assets. Deposits and bank borrowing create interest expenses; securities and loans generate interest income. – The difference between the two is net interest income. The University of Sydney Page 15  Bank Capital and Profitability – Net interest income can also be expressed as a percentage of total assets to yield: net interest margin. – This is the bank’s interest rate spread - the weighted average difference between the interest rate received on assets and the interest rate paid for liabilities. – Well-run banks have a high net interest income and a high net interest margin. – If a bank’s net interest margin is currently improving, its profitability is likely to improve in the future. The University of Sydney Page 16  Off-Balance-Sheet Activities To generate fees, banks engage in numerous off-balance-sheet activities. 1. Lines of credit - similar to limits on credit cards. – The firm pays a bank a fee in return for the ability to borrow whenever necessary. – The payment is made when the agreement is signed and firm receives a loan commitment. – When the firm has drawn down the line of credit, the transaction appears on the bank’s balance sheet. The University of Sydney Page 17  Off-Balance-Sheet Activities 2. Letters of credit – These guarantee that a customer of the bank will be able to make a promised payment. – Customer might request that the bank send a commercial letter of credit to an exporter in another country guaranteeing payment for the goods on receipt. – In return for taking this risk, the bank receives a fee. The University of Sydney Page 18  Off-Balance-Sheet Activities 3. Standby letter of credit – Standby letters of credit are letters issued to firms and governments that wish to borrow in the financial markets – They act as a form of insurance. – These activities expose a bank to risk that is not readily apparent on their balance sheet. – By allowing for the transfer of risk, modern financial instruments enable individual institutions to concentrate risk in ways that are very difficult for outsiders to discern. The University of Sydney Page 19  Bank Risk: Where It Comes from and What to Do about It – The bank’s goal is to make a profit in each of its lines of business. – They want to pay less for the deposits they receive than for the loans they make and the securities they buy. – In the process of doing this, the bank is exposed to a host of risks: – Liquidity risk – Credit risk – Interest-rate risk – Trading risk The University of Sydney Page 20  Liquidity Risk – Liquidity risk is the risk of a sudden demand for liquid funds. – Banks face liquidity risk on both sides of their balance sheets. – Deposit withdrawal is a liability-side risk. – Things like lines of credit are an asset-side risk. – Even if a bank has a positive net worth, illiquidity can still drive it out of business. The University of Sydney Page 21  Liquidity Risk – In the past, the common way to manage liquidity risk was to hold excess reserves. – This is a passive way to manage liquidity risk. – Holding excess reserves is expensive, because it means forgoing higher rates of interest that can be earned with loans or securities. – There are two other ways to manage liquidity risk. – The bank can adjust its assets or its liabilities. The University of Sydney Page 22  Liquidity Risk On the asset side a bank has several options. 1. The easiest option is to sell a portion of its securities portfolio. – Most are U.S. treasuries and can be sold quickly at relatively low cost. – Banks that are particularly concerned about liquidity risk can structure their securities holdings to facilitate such sales. 2. A second possibility is for the bank to sell some of its loans to other banks. – Banks generally make sure that a portion of the loans they hold are marketable for this purpose. 3. Another way is to refuse to renew a customer loan that has come due. – However this is bad for business. The bank can lose a good customer. Reducing assets lowers profitability. The University of Sydney Page 23 The University of Sydney Page 24  Liquidity Risk Bankers prefer to use liability management to address liquidity risk. 1. Banks can borrow to meet any shortfall either from the Fed or from another bank. 2. The bank can attract additional deposits. – This is where large certificates of deposits are valuable: They allow banks to manage their liquidity risk without changing the asset side of their balance sheet. The University of Sydney Page 25 The University of Sydney Page 26  Liquidity Risk – In the financial crisis of 2007-2009, banks could neither sell their illiquid assets nor obtain funding at a reasonable cost to hold those assets. – When the interbank lending and wholesale money markets dried up, many banks faced a threat to their survival. The University of Sydney Page 27  Credit Risk – Credit risk is the risk that a bank’s loans will not be repaid. – Banks use a variety of tools to manage credit risk: 1. Diversification, where banks make a variety of different loans to spread the risk. 2. Credit risk analysis, where the bank examines the borrower’s credit history to determine the appropriate interest rate to charge. The University of Sydney Page 28  Credit Risk – Diversification can be difficult for banks, especially if they focus on a certain type of lending. – If a bank lends in only one geographic area or one industry, it is exposed to economic downturns that are local or industry-specific. – It is important that banks find a way to hedge these risks. The University of Sydney Page 29  Credit Risk – Credit risk analysis uses a combination of statistical models and information that is specific to the loan applicant – The result is an assessment of the likelihood that a particular borrower will default. – In the financial crisis of 2007-2009, banks underestimated the risks associated with mortgage and other household credit. The University of Sydney Page 30  Interest-Rate Risk – A bank’s liabilities tend to be short-term, while assets tend to be long term. – The mismatch between the two sides of the balance sheet creates interest-rate risk. – When interest rates rise, banks face the risk that the value of their assets will fall more than the value of their liabilities, reducing the bank’s capital. – Rising interest rates reduce revenues relative to expenses, directly lowering a bank’s profits. The University of Sydney Page 31  Interest-Rate Risk – The term interest-rate sensitive means that a change in interest rates will change the revenue produced by an asset. – For a bank to make a profit, the interest rate on its liabilities must be lower than the interest rate on its assets. – The difference in the two rates is the bank’s net interest margin. – When a bank’s liabilities are more interest-rate sensitive than its assets, an increase in interest rates will cut into the bank’s profits. The University of Sydney Page 32  Interest-Rate Risk – The first step in managing interest-rate risk is to determine how sensitive the bank’s balance sheet is to a change in interest rates. – Managers must compute an estimate of the change in the bank’s profit for each one-percentage-point change in the interest rate. – This procedure is called gap analysis. – This can be refined to take account of differences in the maturity of assets and liabilities, but it gets complicated. The University of Sydney Page 33 The University of Sydney Page 34  Interest-Rate Risk Bank managers can use a number of tools to manage interest-rate risk. 1. They can match the interest-rate sensitivity of assets with that of liabilities. – Although this decreases interest-rate risk, it increases credit risk. 2. Alternatives include the use of derivatives, specifically interest-rate swaps. The University of Sydney Page 35  Trading Risk – Today banks hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital. – Risk that the instrument may go down in value rather than up is called trading risk, or market risk. – Traders normally share in the profits from good investments, but the bank pays for the losses. – This creates moral hazard - traders take more risk than the banks would like. The University of Sydney Page 36  Trading Risk – The solution to the moral hazard problem is to compute the risk the traders generate. – Use standard deviation and value at risk. – The bank’s risk manager limits the amount of risk any individual trader is allowed to assume and monitors closely. – However, large banks find it difficult to monitor their traders and the managers who are supposed to be monitoring. The University of Sydney Page 37  Trading Risk – Because of this, multi-million dollar losses from trading are common at large banks, even those that are well managed. – The higher the inherent risk in the bank’s portfolio, the more capital the bank will need to hold. The University of Sydney Page 38  Cyber Risk and Other Operational Risks – Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems. – Cyber risk is the losses that arise when information technology systems fail or are compromised. – The financial sector is vulnerable and a target because they are reliant on information and communications technology and have enormous databases. The University of Sydney Page 39  Cyber Risk and Other Operational Risks – The banks must make sure their computer systems and buildings are sufficiently robust to withstand potential disasters. – This means anticipating what might happen and testing to ensure a system’s readiness. The University of Sydney Page 40  Summary of Sources and Management of Bank Risk The University of Sydney Page 41  Homework problems – CS chapter 12 – Problems 3, 7, 8, 12, 16, 18 – Data exploration problems 2-4 The University of Sydney Page 42