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Chapter 19
Bank Management
Financial Markets and Institutions, 7e, Jeff Madura
Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
Bank management
Managing liquidity
Managing interest rate risk
Managing credit risk
Managing market risk
Operating risk
Managing risk of international operations
Bank capital management
Management based on forecasts
Bank restructuring to manage risks
Integrated bank management










3
Bank Management
The goal behind managerial policies of a bank is
to maximize the wealth of the banks
shareholders
Managers may be tempted to make decisions
that are in their own best interests
Banks can incur agency costs
Banks could provide stock as compensation to managers to
maximize the banks stock price
Banks with a low stock price may become takeover targets








4
Bank Management (contd)
Board of directors
The board of directors oversees operations of the
banks and attempts to ensure that managerial
decisions are in the best interests of shareholders
Bank boards tend to contain a higher percentage of
outside members than boards of other types of firms
Functions of bank directors are to:
Determine a compensation system for bank executives
Ensure proper disclosure of the financial condition and
performance
Oversee growth strategies such as acquisitions
Oversee policies for changing capital structure
Assess performance and ensure that corrective action is
taken if there is weak performance








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Managing Liquidity
Banks can experience illiquidity when cash outflows
exceed cash inflows
Illiquidity can be resolved by creating additional liabilities or
selling assets
Banks should maintain the level of liquid assets that will
satisfy their liquidity needs but use their remaining funds
to satisfy their other objectives
Research has shown that high-performance banks are able to
maintain relatively low liquidity
Use of securitization to boost liquidity
Securitization commonly involves the sale of assets by the bank
to a trustee who issues securities that are collateralized by the
assets
Securitization converts future cash flows into immediate cash










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Managing Interest Rate Risk
Bank performance is influenced by the interest
payments earned relative to the interest paid:



During a period of rising interest rates, a banks net interest
margin will likely decrease if its liabilities are more rate sensitive
than its assets (see next slide)
During a period of decreasing interest rates, a banks net
interest margin will likely increase if its liabilities are more rate
sensitive than its assets (see next slide)









Assets
expenses Interest - revenues Interest
margin interest Net =
7
Managing Interest Rate Risk
(contd)
%
%
Time
Time
Rate on Loans
Cost of Funds Spread
Increasing Interest Rates Decreasing Interest Rates
Cost of Funds
Rate on Loans
8
Managing Interest Rate Risk
(contd)
To measure interest rate risk, a bank measures
the risk and then uses its assessment of future
interest rates to decide whether and how to
hedge the risk
Methods used to assess interest rate risk:
Gap analysis
Duration analysis
Regression analysis










9
Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk
(contd)
Gap analysis
Gap is defined as:


The gap ratio is the volume of rate-sensitive assets divided
by rate-sensitive liabilities









s liabilitie sensitive Rate - assets sensitive Rate Gap =
10
Computing A Banks Gap and
Gap Ratio

Philly Bank generated interest revenues of $100 million last year and
$45 million in interest expenses. Philly bank has $2 billion in
assets, of which $800 million are rate-sensitive. Philly also has
$700 million in rate-sensitive liabilities. What are Philly Banks gap
and gap ratio?













% 29 . 114
000 , 000 , 700 $
00 $800,000,0
ratio Gap
000 , 000 , 100 $
000 , 000 , 700 $ 000 , 000 , 800 $
s liabilitie sensitive Rate - assets sensitive Rate Gap
= =
=
=
=
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Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk
(contd)
Gap analysis (contd)
Banks often classify assets and liabilities into categories
based on the time of repricing and calculate a gap for each
category
Banks must decide how to classify their liabilities and assets
as rate sensitive versus rate insensitive
Each bank may have its own classification system, because
there is no perfect measurement of gap








12
Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk
(contd)
Duration measurement
Duration can capture the different degrees of interest rate
sensitivity:




The duration of a banks asset portfolio is the weighted
average of the durations of the individual assets

=
=
+
+
=
n
t
t
t
n
t
t
t
k
C
k
t C
1
1
) 1 (
) 1 (
) (
DUR
13
Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk (contd)
Duration measurement (contd)
The bank can also estimate the duration of its liability portfolio and
then estimate the duration gap:


A duration gap of zero means the bank is not exposed to interest
rate risk
Banks with positive duration gaps are adversely affected by rising
interest rates and positively affected by declining interest rates









( ) | | LIAB/AS DURLIAB - DURAS DURGAP =
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Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk
(contd)
Duration measurement (contd)
Assets with shorter maturities have shorter durations
Assets that generate more frequent coupon payments have
shorter durations
The capabilities of duration are limited when applied to
assets that can be terminated on a moments notice









15
Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk
(contd)
Regression analysis
A bank can assess interest rate risk by determining how
performance has historically been influenced by interest
rate movements
A proxy must be chosen for bank performance and for
prevailing interest rates and regression analysis can be
applied:










u i B R B B R
m
+ + + =
2 1 0
16
Managing Interest Rate Risk
(contd)
Methods used to assess interest rate risk (contd)
Regression analysis (contd)
A positive (negative) coefficient suggests that performance is
favorably (adversely) affected by rising interest rates
If the interest rate coefficient is zero, the banks stock returns are
insulated from interest rate movements
The vast majority of research has found that bank stock levels are
inversely related to interest rate movements
Regression analysis can be combined with the value-at-risk
(VAR) method to determine how its market value would change in
response to specific interest rate movements










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Managing Interest Rate Risk
(contd)
Determining whether to hedge interest rate risk
Banks should consider using their measurement of
interest rate risk along with their forecast of interest
rate movements to determine whether they should
hedge
Since none of the measures is perfect for all
situations, some banks measure interest rate risk
using all three methods
In general, the three methods should lead to a
similar conclusion (see next slide)










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Gap Analysis
If the banks gap is:
Negative
Positive
Increase
Increase
Decrease
Decrease
and interest rates
are expected to:
the bank should:
Consider hedging
Remain unhedged
Remain unhedged
Consider hedging
19









Duration Gap Analysis
If the banks
duration gap is:
Negative
Positive
Increase
Increase
Decrease
Decrease
and interest rates
are expected to:
the bank should:
Remain unhedged
Consider hedging
Consider hedging
Remain unhedged
20









Regression Analysis
If the banks
Interest rate coefficient is:
Negative
Positive
Increase
Increase
Decrease
Decrease
and interest rates
are expected to:
the bank should:
Consider hedging
Remain unhedged
Remain unhedged
Consider hedging
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Managing Interest Rate Risk
(contd)
Methods used to reduce interest rate risk
Maturity matching
The bank can match each deposits maturity with an asset
of the same maturity
Very difficult to implement because deposits are short term
Using floating-rate loans
Floating-rate loans allow banks to support long-term assets
with short-term deposits
If the cost of funds is changing more frequently than the
rate on assets, there is still interest rate risk
Could result in increased exposure to credit risk










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Managing Interest Rate Risk
(contd)
Methods used to reduce interest rate risk
(contd)
Using interest rate futures contracts
The sale of a futures contract on Treasury bonds prior to
an increase in interest rates will result in a gain
The size of the banks position in Treasury bond futures is
dependent on the size of its asset portfolio, the degree of
its exposure to interest rate movements, and its forecast of
future interest rate movements










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Managing Interest Rate Risk
(contd)
Methods used to reduce interest rate risk
(contd)
Using interest rate swaps
A bank whose liabilities are more rate sensitive than its
asset can swap payments with a fixed interest rate in
exchange for payments with a variable interest rate over a
specified period of time
If interest rates rise, the bank benefits because the payments
to be received from the swap will increase while its outflow
payments are fixed
A bank whose assets are more rate sensitive than its
liabilities can swap variable-rate payments in exchange for
fixed-rate payments










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Managing Interest Rate Risk
(contd)
Methods used to reduce interest rate risk
(contd)
Using interest rate caps
An agreement to receive payments when the interest rate
of a particular security or index rises above a specified
level during a specified time period can be used to hedge
interest rate risk
During periods of rising interest rates, the cap provides
compensation which can offset the reduction in spread










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Managing Interest Rate Risk
(contd)
International interest rate risk
With foreign currency balances, the strategy of
matching asset and liability interest rate sensitivity
will not automatically achieve a low degree of
interest rate risk











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Managing Credit Risk
Most of a banks funds are used either to make
loans or to purchase debt securities, which
expose the bank to credit risk
Tradeoff between credit risk and expected return
Because a bank cannot simultaneously maximize
return and minimize credit risk, it must compromise
It will select some assets that generate high returns but are
subject to a high degree of credit risk
It will select some assets that are very safe but offer a lower
rate of return
The bank attempts to earn a reasonable return and
maintain credit risk at a tolerable level










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Managing Credit Risk (contd)
Tradeoff between credit risk and expected return
(contd)
How the loan allocation decision affects return and
risk
Credit cards and consumer loans offer the highest margins
above the banks cost of funds
Credit cards and consumer loans will experience more
defaults than other types of loans
Many banks have adopted more lenient credit standards to
generate credit card business
For banks that were too lenient, the wide spread between the
return on credit card loans and the cost of funds has been
offset by a high level of bad debt expenses











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Managing Credit Risk (contd)
Tradeoff between credit risk and expected
return (contd)
Changes in expected return and risk
Banks adjust their asset portfolio according to
changes in economic conditions
Banks generally reduce loans and increase purchases of
low-risk securities when the economy is weak
When economy conditions began to improve in 2003,
banks were more willing to provide more loans subject to
more risk










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Managing Credit Risk (contd)
Measuring credit risk
Banks employ credit analysts who review the financial
information of corporations applying for loans and
evaluate their creditworthiness
Determining the collateral
The bank must decide whether to require collateral than can
back the loan
Determining the loan rate
Ratings are used to determine the premium to be added to
the base rate according to credit risk
Some loans to high-quality customers are commonly offered
at rates below the prime rate










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Managing Credit Risk (contd)
Diversifying credit risk
Banks should diversify their loans to make sure
their customers are not dependent on a common
source of income
Applying portfolio theory to loan portfolios
The variance of an asset portfolios return is:


The covariance measures the degree to which asset
returns move in tandem

= =
=
n
i
n
j
j i j i p
R R COV w w
1 1
2
) , ( o
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Managing Credit Risk (contd)
Diversifying credit risk (contd)
The covariance is equal to the correlation
coefficient between asset returns times the
standard deviation of each assets return, so:


The portfolio variance is positively related to the
correlations between asset returns
If a banks loans are driven by one particular economic
factor, the returns will be highly correlated

= =
=
n
i
n
j
j i ij j i p
w w
1 1
2
o o o
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Managing Credit Risk (contd)
Diversifying credit risk (contd)
Industry diversification of loans
If one particular industry experiences weakness, loans to
other industries will be insulated
Diversifying loans across industries has limited
effectiveness when economic conditions are weak
Geographic diversification of loans
Diversification of loans across districts could achieve
significant risk reduction in loan portfolios because of low
correlations






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Managing Credit Risk (contd)
Diversifying credit risk (contd)
International diversification of loans
Diversification of loans across countries can
reduce exposure to any one country
Banks should assess a countrys risk and focus
on countries with a high country risk rating
The international debt crisis in the 1980s and the
Asian Crisis of 1997 dampened the desire by
banks to diversify loans internationally







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Managing Credit Risk (contd)
Diversifying credit risk (contd)
Selling loans
Banks can eliminate loans that are causing excessive risk
in their portfolios by selling them in the secondary market
Loan sales often enable the bank originating the loan to
continue servicing the loan
Revising the loan portfolio in response to economic
conditions
When economic conditions deteriorate, a banks loan
portfolio may be heavily exposed to economic conditions
even if it has purchased additional Treasury securities







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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, their exposure to market risk has
increased
Banks face increased market risk because of their
increased involvement in the trading of derivatives











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Managing Market Risk (contd)
Measuring market risk
Banks commonly use value-at-risk to measure their
exposure to market risk
Involves determining the largest possible loss that would
occur as a result of changes in market prices based on a
specified confidence level
The bank estimates the impact of an adverse scenario on its
positions based on the sensitivity of the values of its positions
to the scenario
Using the VAR method, the bank can ensure that it has
sufficient capital to cushion against the adverse effects of the
scenarios











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Managing Market Risk (contd)
Measuring market risk (contd)
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
How J.P. Morgan assesses market risk
Uses a 95 percent confidence level to determine the
maximum expected one-day loss on its investments and
credit instruments due to changes in interest rates, foreign
exchange rates, equity prices, and commodity prices












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Managing Market Risk (contd)
Measuring market risk (contd)
Relationship between a banks market risk and
interest rate risk
A banks market risk is partially dependent on its exposure to
interest rate risk
Banks give special attention to interest rate risk because it is
the most important component of market risk
Methods used to reduce market risk
A bank could reduce its involvement in the activities
that cause the high exposure
e.g., reduce the amount of transactions in which it serves as
a guarantor for its clients or reduce its investment in foreign
debt securities












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Operating Risk
Operating risk is the risk resulting from a
banks general business operations
related to:
Information
Execution of transactions
Damaged relationships with clients
Legal issues
Regulatory issues














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Managing Risk of International
Operations
Exchange rate risk
Some international loans contain a clause that allows
repayment in a foreign currency, allowing the
borrower to avoid exchange rate risk
Often, banks convert available funds to whatever
currency corporations want to borrow
Creates an asset denominated in a foreign currency and a
liability denominated in a different currency
The banks profit margin is reduced if the liability currency
appreciates against the asset currency
Banks typically hedge net exposure to exchange rate
risk














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Managing Risk of International
Operations (contd)
Settlement risk:
Is the risk of loss due to settling bank
transactions
e.g., a bank may send its currency to another
bank, but that bank may not send anything back
Can create systemic risk, which is the risk that
many participants will be unable to meet their
obligations because they did not receive
payments on obligations due to them














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Bank Capital Management
Bank operations are different from other types of
firms because the majority of their assets
generate more predictable cash flows
Banks can use a much higher degree of leverage
than other types of firms
Banks must meet the minimum capital ratio required
by regulators
If a bank has too much capital, each shareholder will receive
a smaller proportion of any distributed earnings












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Bank Capital Management (contd)
A common measure of the return to
shareholders is return on equity (ROE):





The greater the leverage measure, the greater the
amount of assets per dollar of equity







Equity
Assets
Assets
taxes after profit Net
measure Leverage (ROA) assets on Return
Equity
taxes after profit Net
ROE
=
=
=
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Computing Banks ROEs

Hidebt Bank and Lodebt Bank each have an ROA of 2
percent. Hidebt Bank has a leverage measure of 13,
while Lodebt Bank has a leverage measure of 9. What
is the ROE for each bank?














% 18 9 % 2
measure Leverage (ROA) assets on Return Lodebt for ROE
% 26 13 % 2
measure Leverage (ROA) assets on Return Hidebt for ROE
= =
=
= =
=
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Bank Capital Management (contd)
Banks can reduce the required level of capital by
selling some loans in the secondary market
Banks required capital is specified as a proportion of
loans
Banks can reduce excessive capital by
distributing a high percentage of their earnings
to shareholders
Capital management is related to dividend policy






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Management Based on Forecasts













Economic
Forecast
Adjustment to
Liability Structure
Adjustment to Asset
Structure
Assessment of Banks
Adjusted Structure
Strong
economy
Concentrate more heavily
on loans; reduce holdings
of low-risk securities
Increased potential for
stronger earnings; increased
exposure of bank earnings
to credit risk
Weak
economy
Concentrate more heavily
on risk-free low-risk loans;
reduce holdings of risky
loans
Reduced credit risk;
reduced potential for
stronger earnings if the
economy does not weaken
Increasing
interest rates
Attempt to attract
CDs with long-term
maturities
Apply floating interest
rates to loans whenever
possible; avoid long-term
securities
Reduced interest rate risk;
reduced potential for
stronger earnings if interest
rates decrease
Decreasing
interest rates
Attempt to attract
CDs with short-term
maturities
Apply fixed interest rates
to loans whenever possible;
concentrate on long-term
securities or loans
Increased potential for
stronger earnings; increased
interest rate risk
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Bank Restructuring to Manage
Risks
Bank operations change in response to
changing regulations and economic conditions
and to managerial policies designed to hedge
risk
Decisions to restructure are complex because of
their effects on customers, shareholders, and
employees
A strategic plan to satisfy customers and
shareholders may not satisfy employees
e.g., many banks downsized in the early 1990s









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Bank Restructuring to Manage
Risks (contd)
Bank acquisitions
Banks can restructure by growing through
acquisitions of other banks
Acquisitions offer advantages:
Economies of scale
Diversification of loans
Acquisitions have disadvantages:
Optimistic projections of cost efficiencies
Employee morale problems and high employee turnover









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Integrated Bank Management
Bank management of assets, liabilities, and
capital is integrated
Asset growth can be achieved only if a bank obtains
the necessary funds
Growth may require an investment in fixed assets that
will require an accumulation of bank capital
An integrated management approach is necessary to
manage liquidity risk, interest rate risk, and credit risk