COMMERCIAL BANKS

INTRODUCTION
A) FUNCTIONS OF COMMERCIAL BANKS
1) Accepting deposits
Banking institutions mobilize savings by issuing their own liabilities which are suited to
the savings and liquidity needs of the saver. These needs are normally safety, liquidity
yield and convenience in conducting transactions.
Banks offer three main types of deposit amounts viz:
a) Checking Accounts (Current accounts) – These allow a customer to withdraw
money on demand. They are convenient, safe and provide a record of payment.
b) Time Deposits – These deposits are placed with banks for specified periods
e.g. one month, three months e.t.c. and cannot be withdrawn before the due date as
this attracts penalties which may include loss of interest accrued.
c) Savings Account – These accounts pay interest on deposits and are popular
with small savers who wish to hold their savings in an interest earning account.
Usually Commercial Banks require a few days notice of withdrawal of money from
savings accounts. Time and savings accounts are desired for their safety, liquidity,
and yield.

2) Administration of Payment Mechanism

Banks manage and operate the payment mechanism in the economy through transfer of
money using their products i.e. checking accounts, cheques, electronic transfers, standing
orders, amongst others.

3) Money Creators
Banks affect the level of money supply through credit creation. A deposit of a given
amount will create several times its value through the multiplier effect generated through
the bank’s lending activity. Lending is one of the primary functions of a commercial bank
and is also the main source of bank revenue.
Lending to customers is mainly done through three main products:
a) Term Loan

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 These are usually loans payable over a period exceeding one year and are amortized
regularly (monthly, quarterly or semi annually) according to the installment agreed in
the loan contract. Bank loans take different forms depending on the needs being
financed e.g. project loans, letters of credit, real estates loans e.t.c.
b) Overdrafts
Overdrafts are a form of standby credit where interest is charged on the portion utilized
and is mainly used by business concerns to meet their working capital requirements. The
overdraft limit approved by the bank is loaded on the borrowers account.

c) By discounting bills exchange

When a bank discounts a bill of exchange (Promissory Note) for a customer, it is making
a payment to a creditor whose debtor has promised to pay at some future date. By
discounting bills, the bank is lending to the creditor and the bank collects the debt when it
is due for payment.

4) Other Bank Services

Besides the functions stated above, banks offer a wide range of services to their
customers. Such services include:
a) Foreign Exchange Business
Banks transact foreign exchange business by obtaining foreign currency for
customers. Importers are able to effect their foreign exchange contracts through use of
bank services.
b) Safe Deposit Services
Banks offer safe custody services for customers’ valuables which may include
jewellery, title deeds, share certificates etc.
c) Trust Services
Banks offer an array of trust services. A trustee assumes the responsibility and
problems of holding and administering some form of asset for the benefit of another
called the beneficiary. Trust Services offered by a bank may include settling estates,
administering trusts and guardianship, administering employee benefit and retirement
plans e.t.c.
d) Acceptance Services

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 B) THE BANK BALANCE SHEET
Banks like other business enterprises are motivated by profits. Banks earn profit mainly by
obtaining funds at relatively low interest rates and lending the funds or investing in securities
at higher interest rates. The spread between the rates banks pay and the rate they earn
determines bank profits. However bank earnings from non-interest income such as fees and
commissions for various other services have grown dramatically and account for a substantial
proportion of bank income.

A typical bank’s balance sheet will portray its assets, liabilities and net worth at a given point
in time.
Total Assets = Total Liabilities + Capital
A bank’s assets indicates what the bank owns or claims the bank has on external entities
(individuals, firms, government and other banks) while its liabilities indicate what the bank
owes or claims external entities have on the bank.

A bank’s net worth also known as capital is a residual item calculated as the difference
between total assets and total liabilities. Capital accounts are the value of the bank owners
residual claim on the bank’s assets i.e. the bank owner’s equity in the bank.

The bank balance sheet can also be viewed as a statement of the source and uses of bank
funds. Banks obtain funds by issuing demand, savings and time deposits, by borrowing funds
from other banks or the public, and by obtaining equity funds from shareholders through
capital accounts. Banks use the funds to grant loans, invest in securities, purchase fixed
assets, and hold reserve in form of currency on hand and deposits at Central Bank.

i) Commercial Bank
Liabilities
Bank liabilities include various types of deposits, other forms of bank borrowing and other
liabilities. Bank deposits are divided into two categories: transactions deposits and non-
transactions deposits.

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 • Transaction Deposits
Transaction deposits are payable on demand – they can be accessed directly or through an
ATM at any time. Transactions (checkable) deposits are deposits on which cheques can be
written with unlimited checking privileges. One can also order the bank to transfer funds to
third party simply by writing a check or authorizing an automatic transfer. Transaction
deposits include demand deposits which are non – interest – bearing checking deposits. They
are the lowest – cost source of funds for banks because depositors are willing to forgo some
interest to have access to a liquid asset that can be used to make purchases.
The bank’s costs of maintaining checkable deposits include costs incurred in servicing these
accounts – processing , preparing and sending out monthly statements, providing efficient
tellers (human or otherwise), maintaining conveniently located branches, and advertising and
marketing to entire customers.

• Non Transaction Deposits

Non-transaction deposits are interest bearing deposits on which no or only a limited number
of cheques can be written eg. Saving accounts, CDs, e.t.c. Non-transaction deposits are the
Largest source of bank funds.

There are two basic types of non-transaction deposits:

Savings accounts and time deposits
Savings accounts are the most common type of non-transaction deposit. Time deposits have a
fixed maturity term ranging from several months to several years and assess substantial
penalties for early withdrawal (loss of interest).

• Borrowings
Commercial banks also obtain funds by borrowing from central bank (the overdraft window).
Loans made by Central bank to Commercial Banks are discount loans. Banks also borrow
funds overnight from other banks while they also borrow from other corporations through
repurchase agreements. Banks borrow funds overnight to have enough deposits at Central
Bank to meet the amount required by CBK.

• Bank Capital

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Bank capital is raised by selling new equity or from retained earnings. Bank capital is a
cushion against a drop in the value of its assets which could force the bank into insolvency
(having liabilities in excess of assets, meaning the bank can be forced into liquidation.Bank
capital is thus a cushion protecting the bank’s owners from potential insolvency due to
contraction in the value of the bank’s total assets. Diminution in the value of a bank capital
accounts is usually a result of operating losses by the bank which could be due to write-offs
of bad debts.

• Other bank liabilities

The ‘other liabilities’ category is relatively small. These include accounts payable – invoices
that have not yet been paid, regular payments on accrual basis that are due on a future date,
accrued taxes, other pay roll expenses and other accrued expenses.

ii) Commercial Bank Assets

A bank uses the funds it has acquired by issuing liabilities to purchase income – earning
assets. Bank assets therefore basically reflect the banks ‘uses of funds’ which have been
financed by funds comprising the banks liabilities which constitute the ‘sources of funds’.
The interest payments earned on these assets comprise the biggest part of bank profits.

i) Reserves
Government Banking regulations require banks to maintain a certain percentage of their
deposit liabilities in the form of non-interest earning legal reserves: A bank’s reserves
include currency and coins in the bank plus the banks deposit balance at Central Bank.
Reserve regulations may thus stipulate that a fraction of a bank’s deposit liabilities must
be kept as reserves with the Central Bank. In Kenya, the reserve requirement in form of a
cash ratio is 4.5% of deposit liabilities.

In addition to the legal reserve also known as required reserves, banks hold additional
reserves, called excess reserves because they are the most liquid of all bank assets and can
be used by a bank to meet its obligations for deposits withdrawals either directly by
depositors or through cheque clearing.

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Banking regulations in Kenya require banks to maintain at least 20% of their assets in
liquid assets (cash or near cash)

ii) Cash assets

Cash assets provide banks with the funds to meet reserves requirements and the liquidity
to help meet the potential withdrawal of deposits and to fund new loans.
Cash assets include currency and coins (called vault cash because the funds are kept in
the bank vault after business hours), deposits with other banks, and cash items in the
process of collection – these are assets for the bank because they are claims on other
banks for funds that will be paid in a few days.

Besides helping meet reserves requirements, bank deposits with Central Bank facilitate
check clearing and settlement systems.

iii) Loans
Loans are the largest single source of income for banks providing more than 50% of total
bank revenue. A loan is a liability for the individual or corporation receiving it , but an
asset for a bank because it provides income to the bank.
Loans are typically less liquid than other assets e.g. securities, because they cannot be
turned into cash until the loan matures. If a bank makes a one year loan it cannot get its
funds back until the loan becomes due at the expiry of the period of one year.
Loans also have a higher probability of default than other bank assets. Because of the lack
of liquidity and higher default risk, the bank earns its highest return on loans i.e. loans
yield the highest rate of return among bank assets in compensation for lower liquidity and
higher risk.
The main categories of loans issued by banks are real estate loans mainly for residential
and business properties, business loans and consumer loans. Commercial banks also lend
to each other through the overnight interbank loans

• Real estate loans

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These include long term mortgages on residential and business properties, short term
loans to building contractors and home equity loans.
Real estate loans are relatively illiquid. Some real estate loans involve both interest rate
risk and default risk e.g. banks issuing and holding fixed rate mortgages are at risk when
interest rates rise significantly after the loans are made. The default risk in real estate
loans derives from a possible decline in value of the real estate used as collateral for the
loans. However banks reduce the interest rate risk by issuing variable rate mortgages.
In USA banks are also able to further reduce the risk in real estate and other loans by
packaging individuals mortgages and other loans in securitized form. Securitization
involves the transformation of illiquid assets such as individual mortgages into highly
marketable capital market instruments. Banks bundle a large number of individuals
mortgages or cash loans into standardized packages and sell the packages to institutions
such as life insurance companies and pension funds. The banks originating the individual
and car loans collect monthly interest and principal payments which the banks “pass
through” (after deducting a fee for the service) to the package buyer.

• Business Loans
A large portion of the banks’ demand deposit balances (transactional accounts) are held
by business firms and bankers will accommodate reasonable loan requests from
established businesses in order to retain the deposit accounts and maintain a reputation as
a reliable source of funds.
Banks are better equipped relative to other financial intermediaries such as life insurance
companies, to deal with the problem of asymmetric information involved in business
borrowing. This is due to Banks familiarity with corporate and other business depositors
which allows them to evaluate and monitor prospective borrowers.

In exchange for the business loans advanced, banks may request customers to maintain a
compensating balance, usually a non-interest bearing checking account averaging perhaps
10% of the line of credit.

A compensating balance raises the cost of the business loan to the customers and
compensates the bank for the costs involved in guaranteeing a line of credit.

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• Consumer Loan
These are loans granted by banks to individuals through several arrangements. The loans
could be for durable goods such as motor vehicles or to finance ongoing consumption
such as credit card purchases. Credit cards loans and bank overdraft arrangements
granting on the spot consumer loans that prevent check bouncing are known as instant
credit lines.
Credit cards such as VISA or Master Card, gives the customer a preauthorized line of
credit from the bank issuing the card. Customers use the card to obtain cash advances
from various banks and ATMs accepting the card. Overdraft facilities provide automatic
credit when customers write cheques in excess of their deposit balances.

iv) Securities
Bank’s holding of securities are made up entirely of debt instruments (Treasury Bills and
treasury bonds) as banks are not allowed to hold stocks.

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C) COMMERCIAL BANK MANAGEMENT
In general terms, banks make profits by selling liabilities with one set of characteristics (a
particular combination of liquidity, risk, size, and return.) and using the proceeds to buy
assets with a different set of characteristics. This process is called asset transformation e.g. a
savings deposit held by one person can provide the funds that enable the bank to make a
mortgage loan to another person. The bank has in effect transformed the savings deposit (an
asset held by the depositor) into a mortgage loan (an asset held by the bank).

Commercial banks, like all business firms strive to earn maximum profits, while maintaining
minimum exposure to possible insolvency. To protect against insolvency, a commercial bank
takes precautionary measures ensuring that the value of its assets exceeds the value of its
liabilities at all times. A bank is considered solvent if the bank can in an orderly manner –
over several weeks – sell its assets and obtain sufficient revenues to meet its liabilities. A
bank becomes insolvent if, at any point in time losses from securities, defaulted loans, or
other investments depress the value of the bank’s assets below the value of the bank’s
liabilities.

Bank solvency is different from bank liquidity which is a bank’s ability to immediately meet
currency withdrawals, cheque clearings, withdrawals of CDs as well as fulfill legitimate new
loan demand while abiding by existing reserve requirements. Banks engage in liquidity
management and capital management to maintain financial viability.

i. Liquidity management
Withdrawal of currency and/or clearing of cheques written on a bank reduce the banks
reserves by the amount of the transaction. Conversely, deposit of currency into a bank
account and/or clearing of cheques deposited into a customers account increase the
bank’s reserve shilling for a shilling as the following examples illustrate:
Assume bank A has ample excess reserves and that all deposits have the same
required reserve of ratio of 10% Bank A’s initial balance sheet is as shown hereunder;

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Assets liabilities
Reserve $20 million Deposits $100 million
Loans $80 million bank capital $10 million
Securities $10 million
The banks required reserves are 10% of $100 million, or $10 million. Given that it
holds $20 million of reserves; the bank has excess reserves of $10 million.

If a deposit out flow of $10 million occurs, the bank’s balance sheet becomes

Asset liabilities
Reserves $10 million deposits $90 million
Loans $80 million bank capital $10 million
Securities $10 million

The bank loses $10 million of deposits and $10 million of reserves, but because its
required reserves are now 10% of only $90 million ($9 million) its reserves still
exceeds this by $1 million. Thus, if a bank has ample excess reserves, a deposit
outflow does not necessitate changes in other parts of the balance sheet.

However, if the bank hold insufficient excess reserves e.g. it holds no excess reserves
its initial balance sheet would be:-
Assets liabilities
Reserves $10 million deposits $100 million
Loans $90 million bank capital $ 10 million
Securities $10 million

When it suffers the $ 10 million deposit outflow, its balance sheet becomes;

Assets liabilities
Reserves $0 deposits $90 million
Loans $90 million bank capital $10 million
Securities $10 million
With the withdrawal of $10 million in deposits, the bank has no reserves.

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The bank has four options to eliminate this shortfall;
a) Acquire reserves by borrowing from other banks – Interbank market. The new
balance sheet will be as shown:

Assets liabilities
Reserves $9 million deposits $90 million
Loans $90 million borrowing from other
banks $9 million
Securities $10 million bank capital $10 million

The cost to bank A will be the interest rate on the borrowing.

b) Sell off some of its securities to help cover the deposit outflow:-
Resulting in the following balance sheet

Assets liabilities
Reserves $9 million deposits $90 million
Loans $90 million bank capital $10 million
Securities $1 million

The bank bears the costs and expenses of brokerage and other transaction costs when
it sells these securities.

c) Borrowing from Central Bank through discount loans resulting in the

following balance sheet:

Assets liabilities
Reserves $9 million deposits $90 million
Loans $90 million borrowing from $9 million
Central bank
Securities $10 million bank capital $10 million

The cost of borrowing from Central Bank is the interest payable at the discount rate.

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 d) Finally the bank can acquire the $9 million of required reserves by reducing its
loans by this amount and depositing the $9 million with the central bank
thereby increasing its reserves. This transaction would give the following
balance sheet.
Assets liabilities
Reserves $9 million deposits $90 million
Loans $81 million bank capital $10 million
Securities $10 million

The process of reducing its loans is the bank’s costliest way of acquiring reserves
when there is a deposit outflow as it could lead to disappointed customers leaving the
bank and taking their business elsewhere.

Excess reserves are an insurance against the costs associated with deposit outflow
(withdrawals.) The higher the costs associated with deposit outflow, the more excess
reserves bank will want to hold. The banks are willing to pay the cost of holding
excess reserves (the opportunity cost – being earnings foregone by not holding
income earning such as loans or securities) to insure against losses due to deposit
outflow.

ii. Asset management

To make its profits, a bank must simultaneously seek the highest returns possible on
loans and securities, reduce risk, and make adequate provisions for liquidity by
holding adequate liquid assets.
Banks strive to accomplish their objectives in four ways:

a. Screening potential borrowers to identify those who pose minimum risk in

default i.e. engage in vetting to reduce the adverse selection problem. A bank
however needs to balance its need to minimize default risk to the need to take
advantage of attractive lending opportunities that earn high interest rates.

b. Banks try to purchase securities with high returns and low risk

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 c. In managing their assets, banks must attempt to lower risk by diversifying.
They accomplish this by purchasing different types of assets (short and long
term securities) and giving loans to a broad cross section of customers i.e.
minimize concentration of loans to a particular sector.

d. The bank must manage the liquidity of its assets so that it can satisfy its
reserve requirements without, bearing huge costs. The bank must balance its
desire for liquidity against the increased earnings that can be obtained from
less liquid assets such as loans.

iii Liability Management

Commercial banks had for a long time operated on the notion that their
liabilities were fixed based on the premise that;

a. More than 60% of the sources of bank funds were obtained through
demand deposits (checkable deposits) which by law could not pay interest.
Thus banks could not actively compete with one another for their deposits by
paying interest on them and so the amount for an individual bank was given.

b. The markets for making overnight loans between banks were not well
developed and hence banks rarely borrowed from other banks to meet their
reserve needs. With more recent developments banks were able to leverage
their liabilities to provide them with reserves and liquidity. This has been
mainly through the expansion of the Interbank overnight loan markets and the
development of new financial instruments which enabled the banks to acquire
funds more quickly. This enabled banks to adopt a more flexible liability
management which no longer depended on checking deposits as the primary
source of bank funds but to aggressively set target goals for their asset growth
and support these by acquiring funds (by issuing liabilities) as they were
needed.
Because of the increased importance of liability management most banks now
manage both sides of the balance sheet together in an asset-liability
management committee (ALCO).

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iv. Capital Adequacy Management
Bank capital provides a bank with a financial cushion, such that transitory adverse
development will not cause the bank to become insolvent.
Bank capital is important for three reasons;

a. It helps prevent bank failure:

A bank maintains bank capital to lessen the chance that it will become
insolvent.
A bank which is lowly capitalized may not be able to absorb the bank’s
operating losses which may lead the value of its asses to fall below liabilities
and negative net worth. Such a situation would mean the bank is insolvent and
the owner’s investment could be wiped off.
In Kenya the Banking Act which governs operations of banking business
stipulates both a minimum amount of core capital of Kshs. 350 million for a
bank and a gearing ratio for core capital to risk weighted assets of not less than
8%; a core capital of not less than 8% of total deposit liabilities; and total
capital of net less than 12% of a bank’s total risk weighted assets plus risk
weighted off balance sheet items.

b. It affects returns to equity holders

A basic measure of bank profitability is the return on assets (ROA) i.e. the net
profit after taxes per dollar of assets:

ROA= Net profit after taxes

Assets

The return on assets provides information on low efficiently a bank is being

run, because it indicates how much profits are generated on average by each
dollar of assets.
The owners of the bank are however more interested on Return on Equity
(ROE), which is the net profit after taxes per dollar of equity capital.

ROE = Net Profit after Taxes

Equity capital

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 There is a direct relationship between the return on assets (which measures
how efficiently the bank is run) and the return on equity (which measures the
return on the owner’s investment). This relationship is determined by the
Equity Multiplier (EM) which is the amount of assets per dollar of equity
capital.

EM = Assets
Equity capital

Therefore

Net profit after taxes = net profit after taxes x assets

Equity capital assets equity capital

Which yields ROE = ROA x EM

Given the return on Assets (ROA) the lower the bank capital the higher the
return for the owners of the bank.

c. Trade off between safety and returns to equity holders

Bank capital reduces the probability of the bank being bankrupt, but it is
equally costly because the higher it is the lower will be the return on equity for
a given return on assets.
In more uncertain times, when the possibility of large losses on loans
increases, banks might want to hold more capital to protect the equity holders.
If they have confidence that loan losses will not occur, they might want to
reduce the amount of bank capital, have a high equity multiplier and thereby
increase the return on equity.
d. Bank capital requirements by regulatory authorities
Banks also holds capital because they are required to do so by regulatory
authorities.

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D) MANAGING BANK RISK
Banks are exposed to various types of risks as detailed hereunder:-

I. Default Risk;
This is the risk that a loan will not be repaid

II. Interest Rate Risk

This is the risk that interest rates will rise after securities have been purchased,
depressing the price of the securities. Because bank assets typically have longer
maturities than liabilities; rising interest rates increase the cost of funds without
commensurately increasing the return earned on assets impairing bank profits.

III. Liquidity Risk

IV. Foreign Exchange Rate Risk

This is the risk that exchange rates will move adversely causing loss to the bank.

V. Political or Country Risk

Banks making loans and investments abroad face the risk that their funds or assets
outside the country will be confiscated or otherwise immobilized and prevented from
returning to the country.
Some of these risks can be hedged at a cost through derivatives and other financial
instruments, while others cannot. On average riskier investments are associated with
higher expected rates of return, and banks knowingly take legitimate risks in order to
earn an attractive rate of return.

1. Managing Credit Risk

Banks and other financial institutions need to make good loans that are paid back in full if
they to earn high profits.

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The economic concepts of adverse selection and moral hazard are important in understanding
the principles that banking institutions have to follow to reduce credit risk and make
successful loans. To be profitable, financial institutions must overcome the adverse solution
and moral hazard problems that make loan defaults more likely. And they do this by the
following principles:-
a) Screening and monitoring
Asymmetric information exists in the loan markets because lenders have less
information about the investment opportunities and activities of borrowers
than borrowers do.
Banks strive to minimize the asymmetry by producing information through
two activities – screening and monitoring.

c) Screening
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. Therefore whether it is an individual or corporate
borrower bankers need to obtain and evaluate all possible information to help
them determine whether one is a good credit risk by calculating the applicable
“credit score” – a statistical measure derived from available information on the
likelihood of one being a poor credit risk

d) Specialization in lending
By concentrating its lending on firms in 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 debt.

e) Monitoring and enforcement of Restrictive Covenants

To reduce the moral hazard of a borrower engaging in risky activities that
could lead to default, the lender should write provisions. (Restrictive
covenants) into loan contracts that restrict borrowers from engaging in such
risky activities.

“Note”

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The following types of covenants can be incorporated in the loan agreement to
help the bank either obtain information and be better able to monitor the
activities of the borrower, or restrict them from certain risky activities.

Affirmative covenants may:

 Require borrowers to submit audited accounts every year and
unaudited (management) accounts more regularly
 Maintain minimum balance sheet ratios e.g. gearing ratios, debt ratios,
and liquidity ratios e.t.c.
 Carry a keyman insurance on senior management

Negative covenants-restrain certain actions

 Pledging assets while loan is still outstanding
 Entering into a merger with another concern
 Offering guarantee on loans to third parties

Restrictive covenants – limits latitude of management action

 Restricting dividends payments and potential borrowers
 Setting ceiling on salaries, bonuses and advances to officers and
employees

By monitoring borrower’s activities to see whether they are complying with

the restrictive covenants and by enforcing the covenants if they are not,
lenders ensure that borrowers are not taking on risks at their expense.

b) Long term Customer relationships

A long term customer relationship is another important principle of credit risk
management and provides the following advantages to the bank:
 Long term customer relationships reduce the costs of information
collection and make it easier to screen out bad credit risks e.g. if a
prospective borrower has had a checking or savings account with the bank

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 for a long time, the information on past activity can reveal a lot about the
customer
 The costs of monitoring long-term customers are lower than those for
new customers e.g. if the customer has borrowed from the bank before, the
bank has already established procedures for monitoring that customer
 A borrower with previous relationship will find it easier to obtain a
loan with the bank because the bank has an easier time determining if the
prospective borrower is a good credit risk and incurs fewer costs in
monitoring the borrower.
 A borrower may want to preserve a long term relationship with a bank
because it will be easier to get future loans and will thus have the incentive
to avoid risky activities that would upset the bank.

c) Loan commitments
Banks also create long-term relationships and gather information by issuing loan
commitments to commercial customers. 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 advantage for
the firm is that it has a source of credit when it needs it while the bank benefits from
information collection. Provisions in the loan commitment agreement require that the
firm continually supply the bank with information about the firm’s income, asset and
liability position e.t.c.

d) Collateral and compensating balances

Collateral which is the property promised (charged) to the lender as compensation if
the borrower defaults lessens the consequences of adverse selection because it reduces
the lender’s losses in the case of a loan default.
Compensating balance is a form of collateral and requires that a firm receiving a loan
must keep a specified minimum amount of funds in a checking account at the bank.
The compensating balances can be taken by the bank to make up some of the losses
on the loan if the borrower defaults.

e) Credit rationing

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Another way in which financial institutions deal with adverse selection and moral
hazard is through credit rationing. Credit rationing means refusal by the bank to make
loans even though borrowers are willing to pay higher than market rates and takes two
forms:-
 Refusing to make a loan of any amount
Adverse selection supports this solution since individual and firms with the
riskiest investment projects are the ones willing to pay the highest interest
rates.
 Restricting the size of the loan to less than the borrower would like

Such credit rationing is necessary because the larger the loan the greater the
benefits from moral hazard i.e. the larger the loan the greater the incentive to
engage in activities that make it more likely to default in repayment.

2. Managing Interest – Rate Risk

Interest rate risk refers to the riskness of earnings and returns that is associated
with changes in interest rates. The mismatch in the maturity profile of the
banks assets and liabilities expose the bank to interest rate risk.
Example
BANK A
Assets liabilities
Rate sensitive assets $20 million rate sensitive liabilities $50 million
(Variable rate and (valuable rate Cds)
Short term loans (Money market deposit)
Short term securities) accounts)

Fixed rate assets fixed rate liabilities $50 million

(Reserves) $80 million (checkable deposits)
(Long term loans) (Savings deposits)
(Long term securities) (Long term CDs)
(Equity capital)

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The profile of the banks assets is $20 million in rate sensitive assets and $80 million
in fixed – rate with interest rates that remain fixed for a long time typically over one
year.
The profile of liabilities is balanced between $50 million in rate sensitive liabilities
and $50 million in fixed rate liabilities. An rise of 5% in interest rates will raise
income on assets by $1 million (=5% x 20 million) and raise payment on liabilities by
$ 2.5 million (=$50 million x 5%).
The effect would be to reduce the profits of bank by $1.5 million ($1 million - $2.5
million).
If a bank has more rate sensitive liabilities then assets, a rise in interest rates will
reduce bank profits and decline in interest rates will raise bank profits.

i) Gap analysis
The sensitivity of bank profits to changes in interest rates can be measured more
directly using gap analysis.
The amount of rate sensitive liabilities is substracted from the amount of rate sensitive
assets. This calculation – called the “gap” – in the above example of Bank A is - $30
million (=$20-$50 million). By multiplying the gap times the change in interest rate,
the effect on bank profits can be established immediately. Thus, when interest rates
rise by 5% the change in profits is 5% x $30 million which equals $1.5 million as
established earlier. This analysis is called the basic gap analysis and it can be refined
in two ways:

a) Maturity bucket approach

Not all assets and liabilities in the fixed rate category have the same maturity.
The maturity bucket approach therefore measures the gap for several maturity sub
intervals called maturity buckets, so that the effects of interest – rate changes over
a multiyear period can be calculated.

b) The standardized gap analysis

This approach attempts to account for the differing degrees of rate sensitivity for
different rate – sensitive assets and liabilities.

ii) Duration analysis

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An alternative method for measuring interest rate risk is the duration analysis, which
examines the sensitivity of the market value of the bank’s total assets and liabilities to
changes in interest rates.
Duration analysis involves using the average (weighed) duration of a financial
institution’s assets and of its liabilities to see how its net worth responds to a change
in interest states.

In the above example of Bank A, assume the average duration of its assets is three
years, (i.e. average lifetime of the stream of payments is three years) while the
average duration of it s liabilities is two years. In addition the bank has $ 100 million
of assets and $ 90 million of liabilities, and so its capital is 10% of assets.

With a 5% increase in interest rates, the market value of the banks assets falls by 15%
(=-5% x 3 years), a decline of $15 million of the $100 million of assets. The market
value of the liabilities falls by 10% (= -5% x 2 years), a decline of $ 9 million on the
$90 million of liabilities.
The net result is that the net worth (the market value of assets minus the liabilities)
has declined by $6 million, or 6% of the total original asset value. A 5% decline in
interest rates increase the net worth of the bank by 6% of the total asset value.
Duration analysis and gap analysis are useful tools for determining the degree of
exposure to interest scale risk.

3. Off Balance Sheet Activities

Off balance sheet activities involve trading financial instruments and generating
income from fees, activities that affect bank profits but do not appear on bank balance
sheets.
These activities include the provision by banks of specialized services to their
customers which include:-
 Making foreign exchange trades on customer’s behalf
 Guaranteeing debt securities such as Bankers Acceptances
 Providing backup lines of credit such as standby letters of credit to backup
issues of commercial paper among others. Off balance sheet activities
involving guarantees of securities and back-up credit lines increase the risks a

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bank faces. If the issuer of the security the bank has guaranteed defaults the
bank must pay the security’s owner.

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