1. Copyright© 2006 John Wiley & Sons, Inc. 1
Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th
Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
4. Copyright© 2006 John Wiley & Sons, Inc. 4
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.
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Bank Earnings: Provision for Loan Losses
Provision for loan losses is an expense item
that adds to a bank’s loan loss reserve (a
contra-asset account).
Banks provide for loan losses in anticipation
of credit quality problems in the loan
portfolio.
Loans are written off against the loan loss
reserve
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Bank Earnings: Non-interest income and expense
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.
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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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Dilemma: Profitability vs. Safety
One way for a bank to increase expected profits is to
take on more risk. However, this can jeopardize
bank safety.
For a bank to survive, it must balance the
demands of three constituencies:
shareholders
depositors
regulators
Each with their own interest in profitability and
safety.
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Solvency and Liquidity
Solvency: Maintaining the momentum of a going
concern, attracting customers and financing.
A firm is insolvent when the value of its liabilities
exceeds the value of its assets.
Banks have relatively low capital/asset ratios but
generally high-quality assets.
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.
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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.
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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
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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 “non-
deposit borrowing" (e.g. Fed funds, etc.)
LM supplements asset management, but does not
supersede it
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Definition of Bank Capital
Tier 1 capital or “core” capital includes common
stock, common surplus, retained earnings, non-
cumulative perpetual preferred stock, minority
interest in consolidated subsidiaries, minus
goodwill and other intangible assets.
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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Functions of Bank Capital
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.
Capital is measured against risk-weighted assets.
Risk-weighting is a measure of total assets that
weighs high-risk assets more heavily.
The purpose is to require high-risk banks to hold
more capital than low-risk banks.
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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.
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Managing Credit Risk
The credit risk of an individual loan concerns the
losses the bank will experience if the borrower
does not repay the loan.
The credit risk of a bank’s loan portfolio concerns
the aggregate credit risk of all the loans in the
bank’s portfolio.
Banks must manage both dimensions effectively
to be successful.
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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
The goal is to recover as much as possible
once a problem loan is identified.
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Managing Credit Risk of Loan Portfolio
Internal Credit Risk Ratings are used to
identify problem loans
determine adequacy of loan loss reserves
price loans
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.
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Measuring Interest Rate Risk: Maturity GAP Analysis
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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GAP = RSA – RSL; Positive Gap
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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GAP = RSA – RSL; Negative Gap
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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Managing Interest Rate Risk:Duration GAP Analysis
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.
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Managing Interest Rate Risk: Duration GAP Formula
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.
LALAG D)MV/MV(DD ×−=
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Positive Duration GAP
Assets have longer duration than liabilities; bank expects
interest rates to fall
If interest rates rise—
More assets than liabilities will lose value,
Thus reducing the value of the bank’s equity
If interest rates fall-
More assets than liabilities will gain value,
Thus increasing the value of the bank’s equity
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Negative Duration GAP
Liabilities have longer duration than assets; bank expects
interest rates to rise.
If interest rates rise—
More liabilities than assets will lose value,
Thus increasing the value of the bank’s equity
If interest rates fall—
More liabilities than assets will gain value,
Thus reducing the value of the bank’s 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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Hedging Interest Rate Risk: Asset-Sensitive
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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Hedging Interest Rate Risk: Liability-Sensitive
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
Shorten repricing of assets; lengthen repricing of
liabilities
