Mishkin/Serletis

The Economics
of Money, Banking,
and Financial Markets
Fifth Canadian Edition

Chapter 13

BANKING AND
THE MANAGEMENT OF
FINANCIAL INSTITUTIONS
Copyright 2014 Pearson Canada Inc.

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

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Assets

Reserves
Cash Items in Process of Collection
Deposits at Other Banks
Securities
Loans
Other Assets

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Liabilities
Demand and Notice Deposits
Fixed-Term Deposits
Borrowings
overdraft loans (advances)
settlement balances

Bank Capital

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Balance Sheet of All Banks in

Canada

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Basic Banking
First Bank makes a loan of $100 to a business
and credits the business's chequable deposit
First Bank
Assets
Loans

+$100

Business

Liabilities
Chequable
deposits

+$100

Assets
Chequabl +
e
$100
Deposits

Liabilities
Bank
Loans

+$100

Opening of a chequing account leads to an

increase in the banks reserves equal to the
increase in chequable deposits

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Basic Banking (contd)

When a bank receives additional deposits, it
gains an equal amount of reserves: when it loses
deposits, it loses an equal amount of reserves
First Bank
Assets
Cash items
in process
of
collection

Liabilities

+
$100

Chequabl
e
deposits

+
$100

First Bank
Assets
Reserves

+
$100

Second Bank

Liabilities
Chequable
deposits

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+$100

Assets
Reserves

-$100

Liabilities
Chequable
deposits

-$100

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Basic Banking: Making a Profit

First Bank
Assets

First Bank

Liabilities

Desired
reserves

+$10 Chequable
deposits

Excess
reserves

+$90

+
$100

Assets

Liabilities

Desired
reserves

+$10 Chequable
deposits

Loans

+$90

+
$100

Asset transformation-selling liabilities with one set

of characteristics and using the proceeds to buy
assets with a different set of characteristics
The bank borrows short and lends long

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General Principles of Bank

Management

Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk

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Liquidity Management: Ample

Reserves
with deposit outflow of
$10 million

First Bank
Assets

Liabilities

Reserves

$20M Deposits

Loans

$80M Bank
Capital
$10M

Securities

First Bank

$100M
$10M

Assets

Liabilities

Reserves

$10M Deposits

$90M

Loans

$80M Bank
Capital
$10M

$10M

Securities

If a bank has ample excess reserves, a deposit

outflow does not necessitate changes in other parts
of its balance sheet
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Liquidity Management: Shortfall in

Reserves
with deposit outflow of
$10 million

First Bank
Assets

Liabilities

Reserves

$10M Deposits

Loans

$90M Bank
Capital
$10M

Securities

First Bank

$100M
$10M

Assets
Reserves
Loans
Securities

Liabilities
$0 Deposits
$90M Bank
Capital
$10M

$90M
$10M

Reserves are a legal requirement (in the U.S.) and

the shortfall must be eliminated
Excess reserves are insurance against the costs
associated with deposit outflows
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Liquidity Management: Borrowing

from other Banks

First Bank
Assets
Reserves

Liabilities
$9M Deposits

$90M

Loans

$90M Borrowing

$9M

Securities

$10M Bank Capital

$10M

Cost incurred is the interest rate paid on the

borrowed funds

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Liquidity Management: Securities

Sale

First Bank
Assets
Reserves
Loans
Securities

Liabilities
$9M Deposits

$90M

$90M Borrowing

$0M

$1M Bank Capital

$10M

The cost of selling securities is the brokerage and

other transaction costs

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Liquidity Management: Bank of

Canada Advances

First Bank
Assets
Reserves
Loans
Securities

Liabilities
$9M Deposits
$90M Advances Bank
of Canada
$1M Bank Capital

$90M
$9M
$10M

Borrowing from the Bank of Canada also incurs

interest payments based on the discount rate

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Liquidity Management: Reduce

Loans

First Bank
Assets
Reserves

Liabilities
$9M Deposits

$90M

Loans

$81M Advances Bank

of Canada

$0M

Securities

$10M Bank Capital

$10M

Reduction of loans is the most costly way of acquiring reserves

Calling in loans antagonizes customers
Other banks may only agree to purchase loans at a substantial
discount
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Asset Management: Three Goals

1. Seek the highest possible returns on loans
and securities
2. Reduce risk
3. Have adequate liquidity

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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

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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

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Capital Adequacy Management

Bank capital helps prevent bank failure
The amount of capital affects return for the
owners (equity holders) of the bank
Regulatory requirement

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Capital Adequacy Management:

Preventing Bank Failure
High Bank Capital
Assets

Low Bank Capital

Liabilities

Assets

Liabilities

Reserve
s

$10M Deposits

$90M Reserve
s

$10M Deposits

Loans

$90M Bank
Capital

$10M Loans

$90M Bank
Capital

High Bank Capital

Assets

$10M Deposits

Loans

$85M Bank
Capital

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$4M

Low Bank Capital

Liabilities

Reserve
s

$96M

Assets

$90M Reserve
s
$5M Loans

Liabilities

$10M Deposits

$96M

$85M Bank
Capital

-$1M

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Capital Adequacy Management:

Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes
assets

equity capital
assets
equity capital
ROE = ROA EM
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Capital Adequacy Management:

Safety
Benefits the owners of a bank by making
their investment safe
Costly to owners of a bank because the
higher the bank capital, the lower the return
on equity
Choice depends on the state of the economy
and levels of confidence

Copyright 2014 Pearson Canada Inc.

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Strategies for Managing Bank

Capital
To

To

raise the equity multiplier:

Buying back some of Banks stock
Pay out higher dividend to shareholders
Keeping bank capital constant, acquire new funds
and increase assets
lower the equity multiplier:
Issue more common stock
Reducing dividend to shareholders
Keeping bank capital constant, Issue fewer loans
or sell securities and use proceeds to reduce
liabilities

Copyright 2014 Pearson Canada Inc.

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Application: How a Capital Crunch

Caused a Credit Crunch During the
Global Financial Crisis

Shortfalls of bank capital led to slower credit

growth
Huge losses for banks from their holdings of
securities backed by residential mortgages
Losses reduced bank capital

Banks could not raise much capital on a

weak economy, and had to tighten their
lending standards and reduce lending

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Managing Credit Risk

A major component of many financial
institutions business is making loans
To make profits, these firms must make
successful loans that are paid back in full
The concepts of moral hazard and adverse
selection are useful in explaining the risks
faced when making loans

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Managing Credit Risk: Adverse

Selection
Adverse selection is a problem in loan
markets because bad credit risks (those
likely to default) are the one which usually
line up for loans
Those who are most likely to produce an
adverse outcome are the most likely to be
selected

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Managing Credit Risk: Moral Hazard

Moral hazard is a problem in loan markets
because borrowers may have incentives to
engage in activities that are undesirable from
the lenders point of view
Once a borrower has obtained a loan, they are
more likely invest in high-risk investment
projects that might bring high rates of return if
successful
The high risk, however, makes it less likely the
loan will be repaid
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Managing Credit Risk (contd)

To be profitable, lending firms must overcome
adverse selection and moral hazard problems
Attempts by the lending institutions to solve
the problems explains a number of principles
for managing risk

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Managing Credit Risk (contd)

Screening and Monitoring
Screening
Specialization in Lending
Monitoring and Enforcement of Restrictive Covenants

Long-term customer relationships

Loan commitments
Collateral and compensating balances
Credit rationing
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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

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Managing Interest-Rate Risk

First National Bank
Assets
Rate-sensitive assets

Liabilities
$20M Rate-sensitive liabilities

Variable-rate and short-term

loans

Variable-rate CDs

Short-term securities

Money market deposit

accounts

Fixed-rate assets

$80M Fixed-rate liabilities

Reserves

Checkable deposits

Long-term loans

Savings deposits

Long-term securities

Long-term CDs

$50M

$50M

Equity capital

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Gap Analysis
The Gap is the difference between interest
rate sensitive liabilities and interest rate
sensitive assets
GAP = rate-sensitive assets rate-sensitive liabilities
GAP = RSA RSL

A change in the interest rate (i) will change

bank income (depending on the Gap
Income = GAP i
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Duration Analysis (contd)

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 institutions
net worth to changes in interest rates

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Duration Analysis (contd)

%P = - DUR x [i/(1+i)]
Where:

P is the market value

%P = (Pt+1 Pt)/P
DUR = duration
i = interest rate

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Duration Analysis (contd)

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
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Off-Balance-Sheet Activities
Loan sales (secondary loan participation)
Generation of fee income
Trading activities and risk management
techniques
Futures, options, interest-rate swaps, foreign
exchange
Speculation

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Off-Balance-Sheet Activities
(contd)
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

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Off-Balance-Sheet Activities
(contd)
Internal controls to reduce the principalagent problem
Separation of trading activities and bookkeeping
Limits on exposure
Value-at-risk
Stress testing

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