Bank Management Chapter Objectives •describe the underlying goal, strategy, and governance of banks •explain how banks manage liquidity •explain how banks manage interest rate risk •explain how banks manage credit risk •explain integrated bank management • Bank Goals, Strategy, and Governance •Aligning Managerial Compensation with Bank Goals • Banks may implement compensation programs that provide bonuses to managers that satisfy bank goals. •Bank Strategy §A bank’s decisions on sources of funds will heavily influence its interest expenses on the income statement. §A bank’s asset structure will strongly influence its interest revenue on the income statement. §How Financial Markets Facilitate the Bank’s Strategy To implement their strategy, commercial banks rely heavily on financial markets. (Exhibit 19.1) • Exhibit 19.1 Participation of Commercial Banks in Financial Markets Bank Goals, Strategy, and Governance •Bank Governance by the Board of Directors •Some of the more important functions of bank directors are to: §Determine a compensation system for the bank’s executives. §Ensure proper disclosure of the bank’s financial condition and performance to investors. §Oversee growth strategies such as acquisitions. §Oversee policies for changing the capital structure, including decisions to raise capital or to engage in stock repurchases. §Assess the bank’s performance and ensure that corrective action is taken if the performance is weak because of poor management. Bank Goals, Strategy, and Governance •Bank Governance by the Board of Directors (cont.) §Inside versus Outside Directors §Board members who are also managers of the bank (i.e. inside directors) may sometimes face a conflict of interests because their decisions as board members may affect their jobs as managers. §Outside directors (directors who are not managers) are generally expected to be more effective at overseeing a bank: they do not face a conflict of interests in serving shareholders. • Bank Goals, Strategy, and Governance •Other Forms of Bank Governance §Publicly traded banks are subject to potential shareholder activism. §The market for corporate control serves as a form of governance because bank managers recognize that they could lose their jobs if their bank is acquired. • Managing Liquidity §Banks can experience illiquidity when cash outflows (due to deposit withdrawals, loans, etc.) exceed cash inflows (new deposits, loan repayments, etc.). •Management of Liabilities §They can resolve cash deficiencies by creating additional liabilities or by selling assets. §Some assets are more marketable than others, so a bank’s asset composition can affect its degree of liquidity. Managing Liquidity •Management of Money Market Securities §Bank can ensure sufficient liquidity by using most of their funds to purchase short-term Treasury securities or other money market securities. §Banks must be concerned about achieving a reasonable return on their assets, which often conflicts with the liquidity objective. A proper balance must be maintained. •Management of Loans §The secondary market for loans has improved the liquidity, however this liquidity may lessen as economic condition lessens and demand for selling loans increases. Managing Liquidity •Use of Securitization to Boost Liquidity §The ability to securitize assets such as automobile and mortgage loans can enhance a bank’s liquidity. §The process of securitization involves the sale of assets by the bank to a trustee, who issues securities that are collateralized by the assets. §Collateralized Loan Obligations § Commercial banks can obtain funds by packaging their commercial loans with those of other financial institutions. §Liquidity Problems § Typically preceded by other financial problems such as major defaults on their loans. Managing Interest Rate Risk •Net Interest Margin (spread) is the difference between interest payments received and interest paid: • • §During a period of rising interest rates, a bank’s net interest margin will likely decrease if its liabilities are more rate sensitive than its assets. (Exhibit 19.2) §The deposit rates will typically be more sensitive if their turnover is quicker. (Exhibit 19.3) §A bank measures the risk and then uses its assessment of future interest rates to decide whether and how to hedge the risk. Exhibit 19.2 Impact of Increasing Interest Rates on a Bank’s Net Interest Margin (if the Bank’s Liabilities are More Sensitive Than Its Assets) • Exhibit 19.3 Impact of Decreasing Interest Rates on a Bank’s Net Interest Margin (if the Bank’s Liabilities are More Sensitive Than Its Assets) • Managing Interest Rate Risk •Methods Used to Assess Interest Rate Risk §Gap Analysis - Banks can attempt to determine their interest rate risk by monitoring their gap over time, where: (Exhibit 19.4) •Gap = Rate-sensitive assets – Rate-sensitive liabilities §An alternative formula is the gap ratio, which is measured as the volume of rate sensitive assets divided by rate-sensitive liabilities. §Many banks classify interest-sensitive assets and liabilities into various categories based on the timing in which interest rates are reset . • Exhibit 19.4 Interest-Sensitive Assets and Liabilities: Illustration of the Gap Measured for Various Maturity Ranges for Deacon Bank • Managing Interest Rate Risk •Methods Used to Assess Interest Rate Risk §Duration Measurement • • Managing Interest Rate Risk •Methods Used to Assess Interest Rate Risk §The bank can then estimate its duration gap, which is measured as the difference between the weighted duration of the bank’s assets and the weighted duration of its liabilities, adjusted for the firm’s asset size: 2. • Managing Interest Rate Risk •Methods Used to Assess Interest Rate Risk §Regression Analysis §A bank can assess interest rate risk by determining how performance has historically been influenced by interest rate movements. §This requires that proxies be identified for bank performance and for prevailing interest rates and that a model be chosen that can estimate their relationship. §When a bank uses regression analysis to determine its sensitivity to interest rate movements, it may combine this analysis with the value-at-risk (VaR) method to determine how its market value would change in response to specific interest rate movements. • Managing Interest Rate Risk •Whether to Hedge Interest Rate Risk §A bank can consider the measurement of its interest rate risk along with its forecast of interest rate movements to determine whether it should consider hedging that risk. Managing Interest Rate Risk •Methods Used to Reduce Interest Rate Risk (Exhibit 19.5) •Maturity matching •Using-floating rate loans •Using interest rate futures contracts •Using interest rate swaps •Using interest rate caps • Exhibit 19.5 Framework for Managing Interest Rate Risk • Managing Interest Rate Risk •Methods Used to Reduce Interest Rate Risk §Maturity Matching - match each deposit’s maturity with an asset of the same maturity. §Using Floating-Rate Loans - Allows banks to support long-term assets with short-term deposits without overly exposing themselves to interest rate risk Managing Interest Rate Risk •Methods Used to Reduce Interest Rate Risk (cont.) §Using Interest Rate Futures Contracts §Interest rate futures contracts lock in the price at which financial instruments can be purchased or sold on a specified future settlement date. §Financial futures contracts can reduce the uncertainty about a bank’s net interest margin. (Exhibit 19.6) §Using Interest Rate Swaps - an arrangement to exchange periodic cash flows based on specified interest rates (Exhibits 19.7 & 19.8) 3. Exhibit 19.6 Effect of Financial Futures on the Net Interest Margin of Banks That Have More Rate-Sensitive Liabilities Than Assets • Exhibit 19.7 Illustration of an Interest Rate Swap Exhibit 19.8 Comparison of Denver Bank’s Spread: Unhedged versus Hedged • Managing Interest Rate Risk •Methods Used to Reduce Interest Rate Risk (Cont.) •Using Interest Rate Caps •Agreements (for a fee) to receive payments when the interest rate of a particular security or index rises above a specified level during a specified time period. •During periods of rising interest rates, the cap provides compensation that can offset the reduction in spread during such periods. •International Interest Rate Risk - When a bank has foreign currency balances, the strategy of matching the overall interest rate sensitivity of assets to that of liabilities will not automatically achieve a low degree of interest rate risk. • Managing Credit Risk •Measuring Credit Risk: Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness. §Determining the Collateral §When a bank assesses a request for credit, it must decide whether to require collateral that can back the loan in case the borrower is unable to make the payments. §Determining the Loan Rate §If the bank decides to grant the loan, it can use its evaluation of the firm to determine the appropriate interest rate. §Some loans to high-quality (low-risk) customers are commonly offered at rates below the prime rate. Managing Credit Risk •Measuring Credit Risk (cont.) •Measuring Credit Risk of a Bank Portfolio •Exposure is dependent on types of loans a bank provides. •Larger proportion of financing credit cards, increases exposure to credit risk. •Exposure also changes over time in response to economic conditions. Managing Credit Risk •Trade-off between Credit Risk and Return §If a bank wants to minimize credit risk, it can use most of its funds to purchase Treasury securities. §A bank concerned with maximizing its return could use most of its funds to provide credit card and consumer loans. • Managing Credit Risk •Trade-off between Credit Risk and Return §Expected Return and Risk of Subprime Mortgage Loans §Many commercial banks aggressively funded subprime mortgage loans in the 2004–2006 period by originating the mortgages or purchasing mortgage-backed securities that represented subprime mortgages. §The banks did not anticipate the credit crisis that occurred in the 2008–2009 period and that the value of many homes would decline far below the amount owed on the mortgage. Managing Credit Risk •Reducing Credit Risk §Industry Diversification of Loans - Banks should diversify their loans to ensure that their customers are not dependent on a common source of income. §International Diversification of Loans - Many banks reduce their exposure to U.S. economic conditions by diversifying their loan portfolio internationally. Managing Credit Risk •Reducing Credit Risk (cont.) §Selling Loans - Banks can eliminate loans that are causing excessive risk to their loan portfolios by selling them in the secondary market. §Revising the Loan Portfolio in Response to Economic Conditions – banks continually assess both the overall composition of their loan portfolios and the economic environment. • Managing Market Risk §Market risk results from changes in the value of securities due to changes in financial market conditions such as interest rate movements, exchange rate movements, and equity prices. §As banks pursue new services related to the trading of securities, they have become much more susceptible to market risk. §The increase in banks’ exposure to market risk is also attributed to their increased participation in the trading of derivative contracts. Managing Market Risk •Measuring Market Risk •Banks commonly measure their exposure to market risk by applying the value-at-risk (VaR) method, which involves determining the largest possible loss that would occur as a result of changes in market prices based on a specified percent confidence level. §Bank Revisions of Market Risk Measurements - Banks continually revise their estimate of market risk in response to changes in their investment and credit positions and to changes in market conditions. §Relationship between a Bank’s Market Risk and Interest Rate Risk - Partially dependent on its exposure to interest rate risk. Managing Market Risk •Methods Used to Reduce Market Risk §Could reduce the amount of transactions in which it serves as guarantor for its clients or reduce the bank’s investment in foreign debt securities that are subject to adverse events in a specific region. §Could attempt to take some trading positions to offset some of its exposure to market risk. §Could sell some of its securities that are heavily exposed to market risk. • Integrated Bank Management •Application §Exhibits 19.9, 19.10, & 19.11. §Could attempt to take some trading positions to offset some of its exposure to market risk. • Exhibit 19.9 Balance Sheet of Atlanta Bank (in Millions of Dollars) • Exhibit 19.10 Comparative Balance Sheet of Atlanta Bank • Exhibit 19.11 Evaluation of Atlanta Bank Based on its Balance Sheet Integrated Bank Management •Application (cont.) §Management of Bank Capital §The return to shareholders is the return on equity (ROE): • • • • • • §The ratio (assets / equity) is called the leverage measure because leverage reflects the volume of assets a firm supports with equity. • Managing Risk of International Operations •Exchange Rate Risk §When a bank providing a loan requires that the borrower repay in the currency denominating the loan, it may be able to avoid exchange rate risk. •Settlement Risk §International banks that engage in large currency transactions are exposed not only to exchange rate risk as a result of their different currency positions but also to settlement risk, or the risk of a loss due to settling their transactions. SUMMARY §The underlying goal of bank management is to maximize the wealth of the bank’s shareholders, which implies maximizing the price of the bank’s stock (if the bank is publicly traded). A bank’s board of directors needs to monitor bank managers to ensure that managerial decisions are intended to serve shareholders. §Banks manage liquidity by maintaining some liquid assets such as short-term securities and ensuring easy access to funds (through the federal funds market). SUMMARY (Cont.) §Banks measure their sensitivity to interest rate movements so that they can assess their exposure to interest rate risk. Common methods of measuring interest rate risk include gap analysis, duration analysis, and measuring the sensitivity of earnings (or stock returns) to interest rate movements. §Banks can reduce their interest rate risk by matching the maturities of their assets and liabilities or by using floating-rate loans to create more rate sensitivity in their assets. Alternatively, they could sell financial futures contracts or engage in a swap of fixed-rate payments for floating-rate payments. SUMMARY (Cont.) §Banks manage credit risk by carefully assessing the borrowers who apply for loans and by limiting the amount of funds they allocate toward risky loans (such as credit card loans). They also diversify their loans across borrowers of different regions and industries so that the loan portfolio is not overly susceptible to financial problems in any single region or industry. §An evaluation of a bank includes assessment of its exposure to interest rate movements and to credit risk. This assessment can be used along with a forecast of interest rates and economic conditions to forecast the bank’s future performance.