Chapter 12 - Depository Institutions: Banks and Bank Management

Chapter 12
Depository Institutions: Banks and Bank Management

Chapter Overview

This chapter examines the business of banking, looking at where depository institutions
get their funds and what they do with them. It also examines the sources of banks
liabilities and the ways that they manage their assets. The sources of risk that banks face
are also considered, as well as how that risk can be managed.

Reading this chapter will prepare students to:

Understand banks balance sheets and how they make profit.
Explain the risks in the day-to-day business of banks.
Assess the degree to which banks can manage the risks they face.

Important Points of the Chapter

Banks are the most visible financial intermediaries in the economy. These depository
institutions accept deposits from savers and make loans to borrowers. They include
commercial banks, savings and loans, and credit unions. Banks seek to profit from their
various lines of business; they provide accounting and record keeping services, provide
access to the payments system, pool the savings of small depositors and use the funds to
make loans to borrowers, and they offer customers risk-sharing services. Banks are
important, and when they are poorly managed the entire economy suffers.

Application of Core Principles

Principle #1: Time. Banks hold only 3% of their assets as cash because holding cash is
expensive; it earns no interest.

Principle #3: Information. Among a banks off-balance sheet activities is the provision
of a line of credit to a trusted customer. Since the bank usually knows the customer to
whom it grants the line of credit, the cost of establishing creditworthiness (an information
cost) is negligible.

Principle #2: Risk. Banks are exposed to a host of risks, including liquidity risk, credit
risk, interest-rate risk, trading risk, and operational risk.

Principle #1: Time. Holding excess reserves is expensive, since it means forgoing the
interest that could be earned on loans or securities.

Principle #3: Information. Since banks specialize in information gathering, they attempt
to gain a competitive advantage in a narrow line of business. The problem is that doing
so exposes the bank to added risks.

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Teaching Tips/Student Stumbling Blocks

Heres a great introduction to the topic of this chapter. Start with the section Your
Financial World: Choosing the Right Bank for You and follow up with this very
short (maybe 5 questions) quiz (by Holden Lewis) on the website of
Bankrate.com. Designed to help people decide if a virtual bank is right for them,
respondents click on the answers to the questions, and then submit the responses
and see the feedback. The site can be found at:
http://www.bankrate.com/brm/news/emoney/equiz1.asp

Chapter 12 builds on students understanding of Core Principles 1, 2 and 3, as

well as the material in Chapter 5 (on how to compute expected returns on assets
and how to measure the risk on those assets), as well as the coverage of
information problems from Chapter 11.

A number of your students may not have bank accounts of their own; a good
exercise might be to have students comparison shop in the area for the best deal
they could get on a checking account.

Some students, particularly if they have no background in accounting, may have

difficulty with the terms equity and assets, the calculations of the ROA and
ROE, and the development of the balance sheet. You may wish to spend extra
time on this material and reinforce with end-of-chapter problems as assignments.

Features in this Chapter

Your Financial World: Choosing the Right Bank for You

Choosing the right bank takes some work; you need to decide why you need a bank and
which one will serve your needs conveniently and cheaply. The Internet has resulted in a
number of bank services being provided over the web. However, if you choose an
Internet bank you should find out if the FDIC insures it.

Tools of the Trade: A Catalog of Depository Institutions

There are three basic types of depository institutions: commercial banks, savings
institutions and credit unions. Commercial banks are further divided into community
banks (small banks with assets of less than $1 billion), regional and super-regional banks,
and money center banks (which do not rely on deposit financing). Savings institutions
include savings and loans and savings banks (the difference being that their depositors
own the savings banks). Credit unions are nonprofit and are owned by people with a
common bond, like a place of employment.

Applying the Concept: Growth and Banking in China and India

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China and India are experiencing phenomenal economic growth rates of 8 to 10 percent
per year. Some people think they would grow even faster if their banks worked properly.
In China, banks account for too large a proportion of the countrys financial system and
are directing resources inefficiently. Indian banks attract too few deposits because people
mistrust banks.

Your Financial World: The Cost of Payday Loans

Check-cashing establishments provide loans to people who cannot borrow from

mainstream financial institutions like banks. They also offer small loans, usually called
payday loans, in which the store will lend up to $500 for a week or two. The problem
with these loans is that there is a fee, and its huge: as much as 15 percent of the
principal amount. And if the borrower renews the loan instead of repaying it, the fees can
amount to much more than the original loan amount.

Lessons from the Crisis: Insufficient Bank Capital

The financial crisis of 2007-2009 and the recession it triggered led to projected losses on
U.S. bank assets of nearly $1 trillion. A banks capital is its net worththe difference
between the value of its assets and its liabilities. The larger this difference the less likely
the bank will be made insolvent by an adverse unexpected event. During the crisis, the
difference was insufficient to cushion against the market risks that surfaced. Many bank
assets were negatively affected by the decline in the market prices of housing, which
lowered the value of MBSs. But holding capital to reduce this risk is costly, so banks did
not. Further, banks increased leverage to boost profits. Highly leveraged firms are
vulnerable even to modes declines in market prices, as the financial crisis proved.

In the News: Rogue Flight: Societe Generales Kerviel Tags Leeson

Jerome Keivel was blamed by Societe Generale SA in January of 2008 for causing a 4.9
billion euro ($7.2 billion) trading loss (the largest in history). Trading tends to attract
competitive people who take risks and push limits.

Lessons of the Article: Trading operations are notoriously difficult to monitor, and
they can go dramatically wrong. The problem is analogous to moral hazard in debt
finance (discussed in Chapter 11). Traders are gambling with someone elses
money, sharing the gains but not the losses from their risk-taking. As a result, they
are prone to taking too much risk and in the cases discussed here, to hiding their
losses when their trades turn sour. This moral hazard presents a challenge to the
banks owners, who must find ways to rein in traders
tendencies to take too much risk. The tip off to unbridled risk-taking can come
when a trader makes too big a profit. Odds are that someone who is making large
profits on some days will register big losses on other days. There is no way to make
a large profit without taking a big risk.

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Applying the Concept: Japanese Banks and U.S. Banks in the 1990s

The poor performance of Japanese banks had two sources: loan losses and capital losses.
But even the data presented probably doesnt show the entire story; a proper accounting
would likely show that most Japanese banks today have negative capital (that is, they are
bankrupt).

Additional Teaching Tools

In the Wall Street Journal article Sweeter Deals for Brokers, Brett Philbin and Annie
Gasparro investigate newly developing pay packages for brokers at Morgan Stanley,
Bank of Americas Merill Lynch Wealth Management, and Smith Barney, signalling a
heating up of the labor market for brokers.

Virtual Tools

Visit the web site of the FDIC to learn more about this insurer of bank deposits:
http://www.fdic.gov/

Heres another bank that only exists in cyberspace: visit Virtual Bank at:
http://www.virtualbank.com/default.asp

Did you know that under the rules of Islam banks cannot charge interest? Learn more
about Islamic Banking at:
http://www.usc.edu/dept/MSA/economics/islamic_banking.html

For More Discussion

Banks in Japan are allowed to own stock while U.S. banks are not. Is this a good idea?
This is a good lead in to the coverage of regulation.

Chapter Outline

I. The Balance Sheet of Commercial Banks

A. Assets: Uses of Funds
1. The asset side of a banks balance sheet includes cash, securities, loans, and
all other assets (which includes mostly buildings and equipment).
2. Cash Items: The three types of cash assets are reserves (which includes cash
in the banks vault as well as its deposits at the Federal Reserve); cash items in
the process of collections (uncollected funds the bank expects to receive); and
the balances of accounts that banks hold at other banks (correspondent
banking).

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3. Securities: The second largest component of bank assets; includes U.S.

Treasury securities and state and local government bonds. Securities are
sometimes called secondary reserves because they are highly liquid and can
be sold quickly if the bank needs cash.
4. Loans: The primary asset of modern commercial banks; includes business
loans (commercial and industrial loans), real estate loans, consumer loans,
interbank loans, and loans for the purchase of other securities. The primary
difference among the various types of depository institutions is in the
composition of their loan portfolios.
B. Liabilities: Sources of Funds
1. Banks need funds to finance their operations; they get them from savers and
from borrowing in the financial markets.
2. There are two types of deposit accounts, transactions (checkable deposits) and
nontransactions.
3. Checkable deposits: A typical bank will offer 6 or more types of checking
accounts. In recent decades these deposits have declined because the accounts
pay low interest rates.
4. Nontransactions Deposits: These include savings and time deposits and
account for nearly two-thirds of all commercial bank liabilities. Certificates
of deposit can be small ($100,000 or less) or large (more than $100,000), and
the large ones can be bought and sold in financial markets.
5. Borrowings: The second most important source of bank funds; banks borrow
from the Federal Reserve or from other banks in the federal funds market.
Banks can also borrow by using a repurchase agreement or repo, which is a
short-term collateralized loan in which a security is exchanged for cash, with
the agreement that the parties will reverse the transaction on a specific future
date (might be as soon as the next day).
C. Bank Capital and Profitability
1. The net worth of banks is called bank capital; it is the owners stake in the
bank.
2. Capital is the cushion that banks have against a sudden drop in the value of
their assets or an unexpected withdrawal of liabilities.
3. An important component of bank capital is loan loss reserves, an amount the
bank sets aside to cover potential losses from defaulted loans.
4. There are several basic measures of bank profitability: return on assets (a
banks net profit after taxes divided by its total assets) and return on equity (a
banks net profit after taxes divided by its capital).

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5. Net interest income is another measure of profitability; it is the difference

between the interest the bank pays and what it receives.
6. Net interest income can also be expressed as a percentage of total assets; that
is called net interest margin, or the banks interest rate spread.
7. Net interest margin is an indicator of future profitability as well as current
profitability.
D. Off-Balance-Sheet Activities
1. Banks engage in these activities in order to generate fee income; these
activities include providing trusted customers with lines of credit.
2. Letters of credit are another important off-balance-sheet activity; they
guarantee that a customer will be able to make a promised payment. In so
doing, the bank, in exchange for a fee, substitutes its own guarantee for that of
the customer and enables a transaction to go forward.
3. A standby letter of credit is a form of insurance; the bank promises that it will
repay the lender should the borrower default.
4. Off-balance-sheet activities create risk for financial institutions and so have
come under increasing scrutiny in recent years.
II. Bank Risk: Where It Comes from and What to Do About It
A. Liquidity Risk
1. Liquidity risk is the risk of a sudden demand for funds and it can come from
both sides of a banks balance sheet (deposit withdrawal on one side and the
funds needed for its off-balance sheet activities on the liabilities side).
2. If a bank cannot meet customers requests for immediate funds it runs the risk
of failure; even with a positive net worth, illiquidity can drive it out of
business.
3. One way to manage liquidity risk is to hold sufficient excess reserves (beyond
the required reserves mandated by the Federal Reserve) to accommodate
customers withdrawals. However, this is expensive (interest is foregone).
4. Two other ways to manage liquidity risk are adjusting assets or adjusting
liabilities.
5. A bank can adjust its assets by selling a portion of its securities portfolio, or
by selling some of its loans, or by refusing to renew a customer loan that has
come due.
6. Banks do not like to meet their deposit outflows by contracting the asset side
of the balance sheet because doing so shrinks the size of the bank.

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7. Banks can use liability management to obtain additional funds by borrowing

(from the Federal Reserve or from another bank) or by attracting additional
deposits (by issuing large CDs).
B. Credit Risk
1. This is the risk that loans will not be repaid and it can be managed through
diversification and credit-risk analysis.
2. Diversification can be difficult for banks, especially those that focus on
certain kinds of lending.
3. Credit-risk analysis produces information that is very similar to the bond-
rating systems and is done using a combination of statistical models and
information specific to the loan applicant.
4. Lending is plagued by adverse selection and moral hazard, and financial
institutions use a variety of methods to mitigate these problems.
C. Interest-Rate Risk
1. The two sides of a banks balance sheet often do not match up because
liabilities tend to be short-term while assets tend to be long-term; this creates
interest-rate risk.
2. In order to manage interest-rate risk, the bank must determine how sensitive
its balance sheet is to a change in interest rates; gap analysis highlights the gap
or difference between the yield on interest sensitive assets and the yield on
interest-sensitive liabilities.
3. Multiplying the gap by the projected change in the interest rate yields the
change in the banks profit.
4. Gap analysis can be further refined to take account of differences in the
maturity of assets and liabilities.
5. Banks can manage interest-rate risk by matching the interest-rate sensitivity of
assets with the interest-rate sensitivity of liabilities, but this approach
increases credit risk.
6. Bankers can use derivatives, like interest-rate swaps, to manage interest-rate
risk.
D. Trading Risk
1. Banks today hire traders to actively buy and sell securities, loans, and
derivatives using a portion of the banks capital in the hope of making
additional profits.
2. However, trading such instruments is risky (the price may go down instead of
up); this is called trading risk or market risk.

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3. Managing trading risk is a major concern for todays banks, and bank risk
managers place limits on the amount of risk any individual trader is allowed to
assume.
4. Banks also need to hold more capital if there is more risk in their portfolio.
E. Other Risks
1. Banks that operate internationally will face foreign exchange risk (the risk
from unfavorable moves in the exchange rate) and sovereign risk (the risk
from a government prohibiting the repayment of loans).
2. Banks manage their foreign exchange risk by attracting deposits denominated
in the same currency as the loans and by using foreign exchange futures and
swaps to hedge the risk.
3. Banks manage sovereign risk by diversification, by refusing to do business in
a particular country or set of countries, and by using derivatives to hedge the
risk.
4. Banks also face operational risk, the risk that their computer system may fail
or that their buildings may burn down.
5. To manage operational risk the bank must make sure that its computer systems
and buildings are sufficiently robust to withstand potential disasters.

Terms Introduced in Chapter 12

bank capital
credit risk
depository institution
discount loans
excess reserves
federal funds market
interest-rate risk
interest rate spread
liquidity risk
loan loss reserves
net interest margin
nondepository institution
off-balance-sheet activities
operational risk
repurchase agreement (repo)
required reserves
reserves
return on assets (ROA)
return on equity (ROE)

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trading risk
vault cash

Lessons of Chapter 12
1. Bank assets equal bank liabilities plus bank capital.
a. Bank assets are the uses for bank funds.
i. They include reserves, securities, and loans.
ii. Over the years, securities have become less important and
mortgages more important as a use for bank funds.
b. Banks liabilities are the sources of bank funds.
i. They include transactions and nontransactions deposits, as well as
borrowings.
ii. Over the years, transaction deposits have become less important as
a source of bank funds.
c. Bank capital is the contribution of the banks owners; it acts as a cushion
against a fall in the value of the banks assets or a withdrawal of its
liabilities.
d. Banks make a profit for their owners. Measures of a banks profitability
include return on assets (ROA), return on equity (ROE), net interest
income, and net interest margin.
e. Banks off-balance-sheet activities have become increasingly important in
recent years. They include
i. Loan commitments, which are lines of credit that firms can use
whenever necessary.
ii. Letters of credit, which are guarantees that a customer will make a
promised payment.

2. Banks face several types of risk in day-to-day business. They include

a. Liquidity risk the risk that customers will demand cash immediately
i. Liability-side liquidity risk arises from deposit withdrawals.
ii. Asset-side liquidity risk arises from the use of loan commitments
to borrow.
iii. Banks can manage liquidity risk by adjusting either their assets or
their liabilities.
b. Credit risk the risk that customers will not repay their loans. Banks can
manage credit risk by:
i. Diversifying their loan portfolios.
ii. Using statistical models to analyze borrowers creditworthiness.
iii. Monitoring borrowers to ensure that they use borrowed funds
properly.
iv. Purchase credit default swaps (CDS) to insure against borrower
default.

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c. Interest-rate risk the risk that a movement in interest rates will change
the value of the banks assets more than the value of its liabilities.
i. When a bank lends long and borrows short, increases in interest
rates will drive down the banks profits.
ii. Banks use a variety of tools, such as gap analysis, to assess the
sensitivity of their balance sheets to a change in interest rates.
iii. Banks manage interest-rate risk by matching the maturity of their
assets and liabilities and using derivatives like interest-rate swaps.
d. Trading risk the risk that traders who work for the bank will create
losses on the banks own account. Banks can manage this risk using
complex statistical models and closely monitoring traders
e. Other risks banks face include foreign exchange risk, sovereign risk, and
operational risk.

Conceptual Problems

1. Banks hold more liquid assets than most businesses do. Explain why.

Answer: Banks are required to meet depositors demands for cash. In order to be able
to do this, they need to hold assets that are relatively liquid. Most businesses do not
need to be able to come up with cash on short notice, so they do not need to hold as
many liquid assets.

2. Explain why banks holdings of cash have increased significantly as a portion of their
balance sheets in recent times?

Answer: Banks hold cash for liquidity purposes - to meet immediate withdrawal
requests from customers. Holding cash is costly for banks, however, due to the
interest foregone on holding alternative assets. With the onset of the financial crisis,
banks dramatically increased their cash holdings, as the possibility of bank runs rose
and other assets became less liquid. Falling interest rates also reduced the
opportunity cost of holding cash. Moreover, in October 2008, the Federal Reserve
began paying interest on bank reserves (one type of cash asset), further reducing the
opportunity cost of holding cash in this form.

3. Why are checking accounts not an important source of funds for commercial banks in
the United States?

Answer: Checkable deposits make up only 10 percent of banks total liabilities. As a

result of financial innovations, consumers can keep their funds in accounts that pay a
higher rate of interest than checking accounts and have funds automatically
transferred to their checking accounts when their balances are low. This has reduced
the importance of checking accounts as a source of funds for commercial banks.

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4. The volume of commercial and industrial loans made by banks has declined over the
past few decades, while the volume of real estate loans has risen. Explain why this
trend occurred and how it contributed to banks difficulties during the financial crisis
of 2007-2009.

Answer: The rise of the commercial paper market enabled businesses to raise funds
directly, diminishing their need to borrow from banks. The creation of mortgage-
backed securities meant that banks did not have to hold the relatively illiquid
mortgage loans they originated on their balance sheets. However, banks purchased a
large amount of these mortgage-backed securities (MBS accounted for about one half
of banks securities holdings in January 2010) and so suffered a significant decline in
the value of their assets when MBS prices plummeted.

5. *Why do you think that U.S. banks are prohibited from holding equity as part of their
own portfolios?

Answer: If a bank owns equity in a company to which it extends a loan, the fact that it
is a part owner of the company can give rise to a conflict of interest. If the company
were to run into trouble with the loan, the bank may be tempted to treat that company
differently. Any perceived financial trouble for the company may reduce the value of
its stock and so adversely impact the value of the banks equity investment.

6. On the Federal Reserve Boards web site, http://www.federalreserve.gov under

Economic Research and Data, Statistical Releases and Historical Data, you will find a
weekly release called H.8, Assets and Liabilities of Commercial Banks in the United
States. For the seven consecutive months shown, look at the trends in:
i) Banks holdings of mortgage-backed securities (both Treasury and
Agency and Other).
ii) Cash assets.
Comment on what you see.

Answer:
i) From August 2009 to February 2010, holdings of Government and Agency
MBS rose from $1,363.1 billion to $1,431.4 billion while other MBS holdings
fell from $208.9 billion to $200.4 billion.
ii) Cash assets rose from $1,013.9 billion to $1,327.8 billion.

7. Explain how a bank uses liability management to respond to a deposit outflow. Why
do banks prefer liability management to asset management?

Answer: Banks can respond to a deposit outflow by borrowing from another bank or
from the Federal Reserve or by issuing large-denomination time deposits. . During
the financial crisis of 2007-2009, banks found it difficult to raise funds through many
of the usual channels and the Federal Reserve introduced additional lending programs

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to help banks manage their liquidity. Banks prefer liability management to asset
management because asset management shrinks the size of a banks balance sheet,
while liability management does not.

8. Banks carefully consider the maturity structure of both their assets and their
liabilities. What is the significance of the maturity structure? What risks are banks
trying to manage when they adjust their maturity structure?

Answer: Banks adjust their maturity structure to manage interest rate risk. Banks
assets tend to be long-term, while their liabilities are generally short-term. If the
short-term interest rate rises, banks will have to pay a higher level of interest on their
liabilities, but the interest income from their assets will stay the same. This will
reduce the banks profits. Banks try to match the interest rate sensitivity of their
assets and liabilities in order to manage this risk.

9. A bank has issued a one-year certificate of deposit for $50 million at an interest rate
of 2 percent. With the proceeds, the bank has purchased a two-year Treasury note
that pays 4 percent interest. What risk does the bank face in entering into these
transactions? What would happen if all interest rates were to rise by 1 percent?

Answer: The bank faces the risk that the short-term interest rate will rise, increasing
the amount of interest the bank has to pay on the CD, but leaving the interest income
that the bank receives from the Treasury note unchanged. With an interest rate of 2
percent for the CD and 4 percent for the Treasury note, the banks annual interest
income is 4% * $50 million = $2 million and the banks annual interest expenses are
2% * $50 million = $1 million. The bank makes a profit of $2 million $1 million =
$1 million. If the interest rate rises 1 percent, the banks profit falls to (4% * $50
million) (3% * $50 million) = $500,000.

10. Define operational risk and explain how a bank manages it.

Answer: Operational risk is the risk that a bank will become physically incapable of
operating (because, for example, its computer systems have failed or its building has
become inaccessible). This risk can be managed by having backup sites that are far
away from the banks primary location.

11. *In response to changes in banking legislation, the past two decades have seen a
significant increase in interstate branching by banks in the United States. How do
you think a development of this type would affect the level of risk in banking
business?

Answer: The increase in interstate branching increases the ability of banks to

diversify their loans across different geographic areas and often different industries.
This would reduce the credit risk banks face.

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Analytical Problems

12. Consider the balance sheets of Bank A and Bank B. If reserve requirements were
10% of transaction deposits and both banks had equal access to the interbank market
and funds from the Federal Reserve, which bank do you think faces the greatest
liquidity risk? Explain your answer.

Answer: On the basis of the information given, Bank B is at greater risk.

The liabilities sides of both balance sheets are the same, so the analysis should
focus on the asset side.
Bank A has a higher level of excess reserves and is therefore better able to meet
unexpected withdrawals by depositors.
In addition, Bank A has a higher level of securities which are generally more
liquid than loans and so could sell them in the market place if funds were needed
immediately.

13. Looking again at Bank A and Bank B, based on the information available, which bank
do you think is at the greatest risk of insolvency? What other information might you
use to assess the risk of insolvency of these banks?

Answer: Bank A has net worth (bank capital) of $320 million while Bank B has net
worth of $100 million. Bank A has more of a cushion against interest rate movements
and so on the basis of the information available Bank B runs the greater risk of
insolvency.
More information on the interest-rate sensitivity of the assets and liabilities of the two
banks would be helpful in further assessing their insolvency risk as would
information on each banks off-balance sheet commitments.

14. Bank Y and Bank Z both have assets of $1 billion. The return on assets for both
banks is the same. Bank Y has liabilities of $800 million while Bank Zs liabilities
are $900 million. In which bank would you prefer to hold an equity stake? Explain
your choice.

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Answer: Your choice will depend on your preference for return versus risk.
If the two banks have $1 billion in assets and have the same return on assets, then net
profit after taxes must be the same for both banks.
Bank Y has bank or equity capital of $200 million while Bank Z has equity capital of
$100 million, so the return on equity is higher for Bank Z.
Bank Z has a higher leverage ratio than Bank Y, however, as a higher portion of its
assets is financed from borrowed funds. Therefore, Bank Z represents a riskier
investment.

15. *You are a bank manager and have been approached by a swap dealer about
participating in fixed for floating interest-rate swaps. If your bank has the typical
maturity structure, which side of the swap might you be interested in paying and
which side would you want to receive?

Answer: A typical bank has liabilities that are shorter-term than its assets or has
floating rate liabilities and fixed rate assets. Because the bank receives fixed interest
payments and has to make floating interest payments, it is at risk when interest rates
rise. To hedge against this risk, the bank should pay fixed and receive floating in the
interest rate swap. That way, when interest rates rise, the receipts from the swap will
increase to offset the higher rates the bank must pay its depositors.

16. If lines of credit and other off-balance sheet activities do not, by definition, directly
affect the balance sheet, how can they influence the level of liquidity risk to which the
bank is exposed?

Answer: With lines of credit, customers pay a fee to the bank for the right to borrow
at their behest. It is the customer, not the bank that determines when the loan is made
and becomes an asset on the banks balance sheet. The bank is obligated to honor its
commitment whenever the customer requests the loan and will need to finance that
loan regardless of its liquidity situation at that point in time. This increases the
liquidity risk faced by the bank.

17. Suppose a bank faces a gap of -20 between its interest-sensitive assets and its interest-
sensitive liabilities. What would happen to bank profits if interest rates were to fall
by 1 percentage point? You should report your answer in terms of the change in
profit per $100 in assets.

Answer: A gap of -20 means that the bank has more interest-sensitive liabilities than
assets. When interest rates fall, therefore, its profits will rise as it gains more on
paying less on its liabilities than it loses in receiving less on its assets.
The gap of -20 implies that profits will rise by 20 cents per $100 of assets.

18. *Duration analysis is an alternative to gap analysis for measuring interest-rate risk.
(See footnote 8 on page 303.) The duration of an asset or liability measures how
sensitive its market value is to a change in the interest rate: the more sensitive, the

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longer the duration. In Chapter 6, you saw that the longer the term of a bond, the
larger the price change for a given change in the interest rate.

Using this information and the knowledge that interest rates increases tend to hurt
banks, would you say that the average duration of a banks assets is longer or shorter
than that of its liabilities?

Answer: When interest rates increase, the market value of assets such as bonds fall. If
interest rate increases hurt banks, then the average value of assets must fall by more
than the average value of liabilities. Given that duration is a measure of the
sensitivity of the market value to a change in interest rates, this implies that the
average duration of bank assets is longer than that of its liabilities.

19. Suppose you were the manager of a bank with the following balance sheet.
Assets Liabilities
Reserves $30 | Checkable Deposits $200
Securities $150 | Time Deposits $600
Loans $820 | Borrowings $100

You are required to hold 10% of checkable deposits as reserves. If you were faced
with unexpected withdrawals of $30 million from time deposits, would you rather
i. Draw down $10 million excess reserves and borrow $20 million from the
Fed?
ii. Draw down $10 million excess reserves and sell securities of $20 million?
Explain your choice.

Answer: Option i) is preferable to option ii) as it doesnt shrink the size of the balance
sheet. Banks would prefer not to reduce the size of their balance sheet as that lowers
their profit.

20. Suppose you are advising a bank on the management of its balance sheet. In light of
the financial crisis of 2007-2009, what arguments might you make to convince the
bank to hold additional capital?

Answer: The financial crisis of 2007-2009 resulted in projected losses of nearly $1

trillion in US bank assets. In the absence of substantial Government support, many
banks would have become insolvent. Holding sufficient capital (the difference
between the value of a banks assets and liabilities) is crucial for maintaining the
banks solvency. While holding capital is costly, there is a trade-off between securing
the solvency of the bank and that cost.

* indicates more difficult problems

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