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Banking and the Management of Financial Institutions

Chapter 13. Banking and the Management of Financial Institutions. Learning Objectives. Outline a bank’s sources and uses of funds Specify how banks make profits by accepting deposits and making loans Discuss how bank managers manage credit risk and interest-rate risk

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Banking and the Management of Financial Institutions

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  1. Chapter 13 Banking and the Management of Financial Institutions

  2. Learning Objectives • Outline a bank’s sources and uses of funds • Specify how banks make profits by accepting deposits and making loans • Discuss how bank managers manage credit risk and interest-rate risk • Explain gap analysis and duration analysis • Illustrate how off-balance-sheet activities affect bank profits

  3. Balance Sheet of All Banks in Canada

  4. Basic Banking Principle • A Bank collects Capital, Paid by shareholders; • keeps it as fractional Reserves, in the form of cash or securities, for Liquidity against Cash Withdrawal, • and make a multiplied amount of loans(Assets) by creating the equal amount of bank money(demand deposit) in the borrowers’ checking account balances(Liablities). • Its interest income comes from the Net Interest Margin(NIM) or difference between loan rates for Assets and deposit rates for Liabilities. • The net profits belongs to Shareholder. The profits can be distributed as dividends or be retained within the bank.

  5. General Principles of Bank Management • Asset Management • Liability Management – Funding Risk Management • Management of Credit Risk + Operation Risk + Market Risk through Internal Capital Adequacy Assessment Process(ICAAP) for Capital Adequacy Requirements(CAR) • Management of Other Risks such as Liquidity Risk, Interest Rate Risk, Reputational Risk, Strategic Risk.

  6. Asset Management: Three Goals • Seek the highest possible returns on loans and securities • Reduce risk • Have adequate liquidity

  7. Asset Management: Four Tools • Find borrowers who will pay high interest rates and have low possibility of defaulting • Purchase securities with high returns and low risk • Lower risk by diversifying • Balance need for liquidity against increased returns from less liquid assets

  8. Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds

  9. Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital affects return for the owners (equity holders) of the bank The most comprehensive measure/index is the Basel Ratio, or the (BIS) (Regulatory) CAR ratio.

  10. We have learned so many financial ratios/indexes, such as

  11. Bank Performance Measures: Returns to Capital paid by Equity Holders

  12. Liquidity Measures • Quick Ratio • Liquidity Ratio • Asset-Capital Multiplier

  13. Risk Measures

  14. Gap Analysis: market risk measurement • The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets GAP = rate-sensitive assets – rate-sensitive liabilities GAP = RSL – RSA • A change in the interest rate (Δi) will change bank income (I) depending on the Gap Income = GAP i

  15. Duration Analysis: Market risk measurement The Duration Gap can be calculated as: DURgap = Dura – (L/A x DURL) Where: Dura = average duration of assets L = market value of liabilities A = market value of assets Durl = average duration of liabilities

  16. Duration Analysis (cont’d) %ΔP = - DUR x [Δi/(1+i)] Where: P is the market value %ΔP = (Pt+1 – Pt)/P DUR = duration gap i = interest rate

  17. Change in Net Worth Formula • D NW/ A = - DUR gap x (Di/1+i)

  18. Duration Analysis (cont’d) • Owners and managers care not only about the change in interest rates on income but also on net worth of the institution • Duration Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates

  19. We now argue that -The most comprehensive Risk Measurement, particularly, Credit Risk is the Basel 1 measurement of Credit Risk: - The Basel 1 Capital Adequacy Requirement Ratio measured Credit Risk only; • The Basel 2 ratio measured Credit Risk and Operational Risks; • The newly revised Basel 3 ratio measures Credit, Operational, and Market Risk.

  20. Measurement In addition to Pillar 1 risks, the newly revised ICAAP encompasses risks for which no capital is allocated, such as business risk, pension risk, and strategic risk. * source: Swedbank’s ICCAP

  21. Capital -Common Equity Tier 1 Capital (= Common Equities + Retained Earnings) -Tier 1 Capital (= CET1 capital + Preferred Shares) -Total Capital (=T1 Capital + Subordinated Debts) For details, refer to the BIS Guide at http://www.bis.org/publ/bcbs189.pdf • Risk Weighted Asset Sum of all assets that the Bank holds times their Credit Risk Weights: http://www.osfi-bsif.gc.ca/eng/docs/car_chpt3.pdf

  22. Regulator Set Minimum CA Ratios

  23. Interest Rate Risk • If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income • If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income

  24. Off-Balance-Sheet Activities go into Market Risk and carry Capital Charges • Loan sales (secondary loan participation) • Generation of fee income • Trading activities and risk management techniques • Futures, options, interest-rate swaps, foreign exchange • Speculation • Proprietary Tradings

  25. Off-Balance-Sheet Activities (cont’d) • Trading activities and risk management techniques • Financial futures, options for debt instruments, interest rate swaps, transactions in the foreign exchange market and speculation • Principal-agent problem arises

  26. Basel 1’s Minimum Adequate Capital Requirements = (Regulator Set minimum) BIS or Capital Adequacy Ratio times RWA Minimum Required Amount of Total Capital (without Capital Conservation Buffer) = 0.8 times RWA

  27. Basel 3’s Minimum Required Total Capital CR for Credit Risk (=CARatio times RWA) Plus CR for Operational Risk Plus CR for Market Risk( for Off Balance Items)

  28. OSFI’s Basel 3 or BIS Ratios or Required Capitalshttp://www.osfi-bsif.gc.ca/Eng/fi-if/rg-ro/gdn-ort/gl-ld/Pages/CAR_chpt1.aspx • http://www.osfi-bsif.gc.ca/Eng/fi-if/rg-ro/gdn-ort/gl-ld/Pages/CAR_chpt1.aspx • 1.5. Calculation of OSFI minimum capital requirements

  29. Off-Balance-Sheet Activities (cont’d) • Internal controls to reduce the principal-agent problem • Separation of trading activities and bookkeeping • Limits on exposure • Value-at-risk • Stress testing

  30. Ultimately, the Enterprise Risk Management should be applied to the banks as well: • http://www.naylornetwork.com/cia-nwl/articles/index-v3.asp?aid=184013&issueID=24062 • The pioneer is Mr. Danny Cooper, Head of Depository Institutions at OSFI. • Actuary- not accounting- approaches to the assessment of all risk faced by the banks

  31. Ultimately, the Enterprise Risk Management should be applied to the banks as well: • http://www.naylornetwork.com/cia-nwl/articles/index-v3.asp?aid=184013&issueID=24062 • The pioneer is Mr. Danny Cooper, Head of Depository Institutions at OSFI. • Actuary- not accounting- approaches to the assessment of all risk faced by the banks

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