Chapter 13: Bank

Management

Financial Markets and

Chapter Objectives
Describe the underlying goal of bank
management
Explain how banks manage liquidity
Explain how banks manage interest rate
risk
Explain how banks manage credit risk
Explain how banks manage capital
Financial Markets and

Goal of Bank Management

The bank manager has four primary concerns
To keep enough cash on hand liquidity
management
To pursue low level of risk asset
management
To acquire funds at low cost liability
management
To maintain the amount of capital capital
adequacy management
Financial Markets and

Goal of Bank Management

The underlying goal of bank
management is to maximize the wealth
of the banks shareholders
Maximizing the share price
Agency costs
Managers not acting in shareholders best
interests
Takeover target
Financial Markets and

Risks Faced By Banks

Liquidity
Risk

Value of
Bank

Interest Rate
Risk

Capital or
Insolvency
Risk

Market
Risk

Value
Related to
Cash Flows
and
Risk of
Cash Flows

Credit Risk

Financial Markets and

Managing Liquidity
Banks experience illiquidity when cash
outflows exceed cash inflows
Banks can resolve cash deficiencies by either
creating additional liabilities or selling assets
Borrowing: fed funds, discount window
Some assets are more liquid than others
Balancing liquidity vs. maintaining a
reasonable return

Financial Markets and

Managing Liquidity
Use of securitization to boost liquidity
Selling off loans to trustee
Mortgage and automobile loans
Trustee issues securities collateralized by the
assets
Loan payments pass through to holders of
securities
Securitization turns future cash flows into
immediate cash
Financial Markets and

Managing Interest Rate Risk

Bank performance is sensitive to interest
received on loans relative to interest paid on
deposits
Difference = net interest margin
Net interest margin =

Interest revenues Interest expenses

Assets

Financial Markets and

Managing Interest Rate Risk

Determining whether to hedge interest rate risk
Banks often use all three methods
Banks use their analysis of gap with interest
rate forecasts to make their hedging decision
Methods of reducing interest rate risk
Maturity matching
Using floating-rate loans
Using interest rate futures contracts
Using interest rate swaps
Using interest rate caps
Financial Markets and

Managing Interest Rate Risk

Methods of reducing interest rate risk
Maturity matching
Match each deposits maturity with an asset
of the same maturity
Difficult to implement
Lots of short term deposits
Using floating rate loans
Often increases credit risk and liquidity risk
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Managing Interest Rate Risk

Methods of reducing interest rate risk
Using interest rate futures contracts
E.g. sale of T-bond futures prior to interest rate
rise results in a gain, offsetting other adverse
effects
Using interest rate swaps
Arrangement to exchange periodic cash flows
based on specific interest rates
Fixed-for-floating
Using interest rate caps
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Managing Credit Risk

Most of a banks funds are used to make loans or
purchase securities
In either case, the bank is subject to credit (or
default) risk
Tradeoff between credit risk and expected return
Investing in Treasuries minimizes credit risk but
also generates a small return
Consumer and small-business loans have a
high return but generate a lot of risk
Cant simultaneously maximize return and
minimize risk
Changes in expected return and risk
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Managing Credit Risk

Measuring credit risk
Requires a credit assessment of loan applicants
Credit analysts
Evaluation indicates the probability of the
firm being able to repay the loan
Determining the collateral
In the event the borrower is unable to repay
Determining the loan rate
Higher risk requires higher rates
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Managing Credit Risk

Diversifying credit risk
Ensures that borrowers are not all dependent on
common source of income
Applying portfolio theory to loan portfolios
Covariance and correlation
If a banks loans are not driven by a common
economic factor then risk will be reduced
Industry diversification of loans
Insulates the bank from a downturn in a single
industry
Geographic diversification of loans
Adjacent areas tend to be more highly correlated in
terms of production levels
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Managing Credit Risk

Diversifying credit risk
International diversification of loans
May not help if the bank accepts loans from
areas with very high credit risk
Selling loans
Problem loans can be removed from the
banks assets
Revising the loan portfolio in response to
economic conditions
In bad economic conditions, businesses are
less able to repay...
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Managing Market Risk

Market risk results from the changes in value of
securities due to changes in financial market
conditions such as interest rates, exchange
rates, and equity prices
Banks have increased exposure to derivatives
and trading activities

Measuring market risk

Banks commonly use value-at-risk (VAR), which
involves determining the largest possible loss
that would occur in the event of an adverse
scenario
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Managing Market Risk

Measuring market risk
Bank revisions of market risk measurements
When changes in market conditions occur, such
as increasing volatility, banks revise their
estimates of market risk
How J.P. Morgan assesses market risk
Calculates a 95 percent confidence interval for
the expected maximum one-day loss due to:
Interest rates, exchange rates, equity prices,
commodity prices, and correlations between
these variables
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Managing Market Risk

Methods of reducing market risk
Reduce involvement in activities that cause
high exposure
Take offsetting trading positions
Sell securities that are heavily exposed to
market risk

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Operating Risk
Operating risk results from a banks
general business operations
Processing and sorting information
Executing transactions
Maintaining relationships with clients
Dealing with regulatory issues
Legal issues

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1. Market Risk

Risk a rising from adverse movements in the level

or volatility of market prices.

2. Credit Risk

The risk that a counterparty will fail to perform on

an obligation.

3. Liquidity Risk

The risk that you may not be able to or cannot easily

unwind or offset a particular position at or near the
previous market price because of inadequate market
depth or because of disruptions in the market.

4. Settlement Risk

The risk that a firm will not receive funds or

instruments from its counterparties at the expected
time.

5. Operational Risk

The risk that deficiencies in information systems or

internal controls will result in unexpected loss. This
risk is associated with human error, system failures
and inadequate procedures and controls.

6. Legal Risk

The risk that contracts are not legally enforceable or

documented correctly.

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Management Based on
Forecasts
Some banks position themselves to
benefit form expected changes in the
economy
If managers expect a strong economy they
may shift toward riskier loans and securities

Inaccurate forecasts have less effect on

more conservative banks

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Bank Restructuring to Manage

Risks

Decisions are complex because they affect

customers, employees, and shareholders
Bank acquisitions
Common form of restructuring
Quick way of achieving growth
Advantages:
Economies of scale, diversification
Managerial advantages
Disadvantages
Purchase price may be too high
Employee morale
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Bank Restructuring to Manage

Risks
Are bank acquisitions worthwhile
Studies show that the market reacts neutrally or
negatively to news of a bank acquisition
May be due to:
Pessimism over whether efficiencies will
be achieved
Personnel clashes
Price may be too high

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Integrated Bank Management

Bank management of assets, liabilities,
and capital is necessarily integrated
An integrated management approach is
also necessary to manage liquidity risk,
interest rate risk, and credit risk

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