The Economics of Money, Banking, and

Financial Markets
Thirteenth Edition

Chapter 9
Banking and the
Management of Financial
Institutions

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Preview
• This chapter examines how banks attempt to maximize
their profits.
• Although the discussion that follows focuses primarily on
commercial banks, many of the same principles apply to
other financial intermediaries as well.

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Direct vs indirect finance

Bank sources of profits:

-Spread of interests
-Commission and fees

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Learning Objectives (1 of 2)
9.1 Summarize the features of a bank balance sheet.
9.2 Apply changes to a bank’s assets and liabilities on a
T-account.
9.3 Identify ways in which banks can manage their
assets and liabilities to maximize profit.

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Learning Objectives (2 of 2)
9.4 List the ways in which banks deal with credit risk.
9.5 Apply gap and duration analysis and identify interest-rate
risk.
9.6 Examine off-balance sheet activities.

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The Bank Balance Sheet (1 of 2)
• Liabilities:
– Checkable deposits-Non interest bearing accounts,
payable on demand, considered as lowest cost
sources of funds for a bank
– Non-transaction deposits- Savings and time deposits
accounts.
– Borrowings(inter banks loans-Overnights, fed reserve
loans- discount loans, bonds)
– Bank capital- Equity- Assets minus Liabilities
– A cushion against a drop in the assets to avoid
bankruptcy event.
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The Bank Balance Sheet (2 of 2)
• Assets:
– Reserves-required by the central bank on current and
savings accounts
– Cash items in process of collection(checks issued by
other banks and credited in the bank account for
collection-Mainly customers checks)
– Deposits at other banks-Short-term investment
purposes
– Securities- Debt vs equity securities hold by the
bank(long-term and short-term)
– Loans-Corporate and retail
– Other assets( Banks buildings and equipments)
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Table 1 Balance Sheet of All Commercial Banks
(Items as a Percentage of the Total, June 2020) (1 of 2)
Assets (Uses of Funds)* Liabilities (Sources of Funds)
Blank Blank

Reserves and cash items 15% Checkable deposits 14%

Securities Nontransaction deposits
Blank Blank

U.S. government and agency 16 Savings deposits 52

State and local government and 4 Small-denomination time deposits 2
other securities
Large-denomination time deposits 9
Blank Blank

Borrowings 10
Blank Blank

Bank capital 13
Blank Blank

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Table 1 Balance Sheet of All Commercial Banks
(Items as a Percentage of the Total, June 2020) (2 of 2)
Assets (Uses of Funds)* Liabilities (Sources of Funds)
Blank Blank

Loans
Blank Blank Blank

Commercial and industrial 14

Blank Blank

Real estate 23
Blank Blank

Consumer 7
Blank Blank

Other 8
Blank Blank

Other assets (for example, 13

Blank Blank

physical capital)
Total 100 Total 100

*In order of decreasing liquidity.

Source: Federal Reserve Bank of St. Louis, FRED database:
http://www.federalreserve.gov/releases/h8/current/ and
https://www.federalreserve.gov/releases/H6/current .

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Basic Banking (1 of 3)
• Cash Deposit:

First First
Blank Blank Blank Blank Blank Blank

National National
Bank Bank
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Vault cash +$100 Checkable +$100 Reserves +$100 Checkable +$100

deposits deposits

• Opening of a checking account leads to an increase in

the bank’s reserves equal to the increase in checkable
deposits.

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Basic Banking (2 of 3)
First National Bank
Blank Blank Blank

Check Deposit:
Assets Liabilities
Blank Blank

Cash items in +$100 Checkable +$100 When a bank receives

process of collection deposits additional deposits, it gains
an equal amount of
reserves; when it loses
deposits, it loses an equal
amount of reserves.

First Second
Blank Blank Blank Blank Blank Blank

National National
Bank Bank
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Reserves +$100 Checkabl +$100 Reserves −$100 negative $100

Checkabl −$100
negative $100

e deposits e deposits

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Basic Banking (3 of 3)
• Making a profit:
First National First National
Blank Blank Blank Blank Blank Blank

Bank Bank
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Required +$10 Checkable +$100 Required +$10 Checkable +$100

reserves deposits reserves deposits
Excess +$90 Loans +$90
Blank Blank Blank Blank

reserves

• 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 and the Role of
Reserves (1 of 6)
• Excess reserves:
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Reserves $20M Deposits $100M Reserves $10M Deposits $90M

Loans $80M Bank $10M Loans $80M Bank $10M

Capital Capital
Securities $10M Securities $10M
Blank Blank Blank Blank

– Suppose a bank’s required reserves are 10%.

– If a bank has ample excess reserves, a deposit outflow
does not necessitate changes in other parts of its
balance sheet(withdrawal of 10M)

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Liquidity Management and the Role of
Reserves (2 of 6)
• Shortfall:
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Reserves $10M Deposits $100M Reserves $0 Deposits $90M

Loans $90M Bank $10M Loans $90M Bank $10M

Capital Capital
Securities $10M Securities $10M
Blank Blank Blank Blank

– Reserves are a legal requirement and the shortfall

must be eliminated.
– Excess reserves are insurance against the costs
associated with deposit outflows.
– The bank needs now 9M to cover the sortfall either via
fed funds market or via borrowings from corprations
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Liquidity Management and the Role of
Reserves (3 of 6)
• Borrowing:

Assets Liabilities
Blank

Reserves $9M Deposits $90M

Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

– Cost incurred is the interest rate paid on the borrowed

such as Fed funds rate (borrowing increased by 9 M)

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Liquidity Management and the Role of
Reserves (4 of 6)
• Securities sale:

Assets Liabilities
Blank Blank

Reserves $9M Deposits $90M

Loans $90M Bank Capital $10M
Securities $1M
Blank Blank

– The cost of selling securities to cover the shortfall is

the brokerage and other transaction costs incurred
especially is the securities sold are less liquid than
others.

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Liquidity Management and the Role of
Reserves (5 of 6)
• Federal Reserve:

Assets Liabilities
Blank Blank

Reserves $9M Deposits $90M

Loans $90M Borrow from Fed $9M
Securities $10M Bank capital $10M

– Borrowing from the Fed also incurs interest payments

based on the discount rate (discount rate loan)

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Liquidity Management and the Role of
Reserves (6 of 6)
• Reduce loans:
Assets Liabilities
Blank Blank

Reserves $9M Deposits $90M

Loans $81M Bank Capital $10M
Securities $10M
Blank Blank

– Reduction of loans is the most costly way of acquiring

reserves.
– Calling in loans annoys customers.
– Other banks may only agree to purchase loans at a
substantial discount.
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Asset Management (1 of 2)
• 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 (2 of 2)
• Four Tools:

1. Find borrowers who will pay high interest rates and

have low possibility of defaulting(screening by the
bank officer to reduce the adverse selection problem).
2. to Purchase securities with high returns and low risk.
3. Lower risk by diversifying-Avoid concentration
risk(short-term and long-term assets, US treasury bills
and bonds, and municipal bonds).
4. Balance the 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) especially by large
banks known as money center banks with low credit
risks.
• Checkable deposits have decreased in importance as
source of bank funds.

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Capital Adequacy Management (1 of 4)
• 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
High capital Bank has a ratio of capital to Assets of 10%
while Low capital bank has a ratio of 4%
Suppose banks get caught up in the euphoria of the
housing market, to find that 5 millions of their housing
loans were written off.
As a result, bank capital (Assets minus liabilities) declines
by 5 million usd.
The balance sheets of the two banks become as follows:
-Low capital bank become insolvent with a negative capital
and thus the bank will be closed.
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Capital Adequacy Management (2 of 4)
How Bank Capital Helps Prevent Bank Failure:
High Low
Blank Blank Blank Blank Blank Blank

Capital Capital
Bank Bank
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million

Loans $90 million Bank $10 million Loans $90 million Bank $ 4 million
capital capital

High Low
Blank Blank Blank Blank Blank Blank

Capital Capital
Bank Bank
Assets Liabilities Assets Liabilities
Blank Blank Blank Blank

Reserves $10 million Deposits $90 million Reserves $10 million Deposits $96 million
negative $1 million
Loans $85 million Bank $ 5 million Loans $85 million Bank −$1 million
capital capital

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Capital Adequacy Management (3 of 4)
How the Amount of Bank Capital Affects Returns to Equity Holders:
Return on Assets: net profit after taxes per dollar of assets-It shows how much
profits are generated by each dollar of Assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital-it shows how

much the bank is earning on their equity investment

net profit after taxes
ROE =
equity capital

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Capital Adequacy Management (4 of 4)
• Trade-off between safety and returns to equity holders:
– 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-ROE
formula
– Choice depends on the state of the economy and
levels of confidence-In more uncertain times, when
possibility of large losses on loans increases bank
managers might want to hold more capital to protect
equity holders.

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Application: Strategies for Managing
Bank Capital

• As the manager of the First National Bank, you have to

make decisions about the appropriate amount of bank
capital to hold in your bank.
• Our discussion of the strategies for managing bank
capital leads to the following conclusion, which deserves
particular emphasis: a shortfall of bank capital is likely to
lead a bank to reduce its assets and therefore is likely to
cause a contraction in lending.

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Application: How a Capital Crunch Caused a
Credit Crunch During the Global Financial Crisis
in 2008

• 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
(very difficult to issue financial securities to raise funds in
such circumstances) and thus had to tighten their lending
standards and reduce lending in order to preserves the
reserves they had to offset losses.

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Managing Credit Risk (1 of 2)
Since asymmetric information is present in loan markets
because lenders have less information about activities of
borrowers than borrowers do.
This situation leads to two information producing activites
by banks:
• Screening and Monitoring:
– Screening
– Specialization in lending
– Monitoring and enforcement of restrictive
covenants

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 Managing Credit Risk
Screening
Adverse selection in loan markets requires that lenders screen out the
bad risks from the good ones so that loans are profitable to them.
• To accomplish effective screening, lenders must collect reliable
information from prospective borrowers who are asked to fill in
forms that include information about their salaries, bank accounts,
and other assets they own.
• As well as personal information about their marital status, age, and
number of children. These information help the lender evaluate the
credit risk and calculate credit score.
• (The same applies for corporate loans but on the corporate level
including site visits and financial statements)
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Managing Credit Risk
Specialization in lending
This type of lending such as banks specialized in housing
or agricultural loans expose the financial institution to
Concentration risk.

At the same time, the bank becomes more knowledgeable

about these industries and better able to predict which
customer will be able to make timely payments on their
debt.

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Managing Credit Risk
Monitoring and enforcement of restrictive covenants
Financial institutions must adhere to the principle for
managing credit risk that a lender should write
provisions(restrictive covenants) into loan contracts that
restrict borrowers from engaging in risky activities.
-By monitoring borrowers activities to see whether they are
complying by the covenants and by enforcing them, lenders
would make sure that borrowers are not taking risks at their
expense- Site visits, financial statements, monitoring bank
statements, gathering information via information
department
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 Managing Credit Risk
• Long-term customer relationships-the bank has already the
whole information including bank statements that would indicate
the liquidity ratio the customer have. Thus, granting a loan for
an existing customer is much easier than a prospective.
• Loan commitments: A loan commitment is a bank commitment
for a specified period of time to issue loans for a customer up to
a given amount and with interest rate tied to market-This fosters
the long-term relationship with the customer and support the
bank in gathering information.
• Collateral and compensating balances: reduce moral hazard
and losses on a bank in case of default especially with the
principle of collateral and compensating balances kept by the
customer blocked on their accounts around 10% of loan
amount.
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Managing Credit Risk
• Credit rationing is the fact of granting loans to customer
but in way not to completely fulfill their demands.

Granting a part of the amount requested especially when a

bank is willing to avoid any potential credit risk with the
customer will help also avoid the moral hazard by the
customer, since he/she did not receive the full amount
needed and they will aim at re-applying for a new loan in
the future.

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Managing Interest-Rate Risk: Gap
Analysis

First National
Blank Blank Blank

Bank
Assets Liabilities
Blank Blank

Rate-sensitive assets $20 million Rate-sensitive liabilities $50 million

Variable-rate and short-term Variable-rate CDs

Blank Blank

loans
Short-term securities Money market deposit
Blank Blank

accounts
Fixed-rate assets $80 million Fixed-rate liabilities $50 million

Reserves Checkable deposits

Blank Blank

Long-term loans Savings deposits

Blank Blank

Long-term securities Long-term CDs

Blank Blank

Equity capital
Blank Blank Blank

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Managing Interest-Rate Risk: Gap
Analysis
• Suppose interest rate increase by 5%, the income on Assets
increases by USD 1 million (20M* 5%) while the payments
on the liabilities increases by USD 2.5 M(50M*5%), the bank
profits now decline by USD1.5 M(1-2.5M)
• Suppose now interest rate decreases by 5%, the income on
Assets decreases by USD 1million while the payments on
liabilities decreases by USD 2.5 M, the bank profits
increases now by USD 1.5 M
If a bank has a more sensitive liabilities than Assets, a
rise in interest rate will reduce bank profits and a decline
in interest rate will raise bank profits.

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Gap and Duration Analysis (1 of 2)
• Basic gap analysis:

( rate sensitive assets − rate sensitive liabilities ) × ∆

interest rates = ∆ in bank profit
(20M-50M) * 5%= -1.5M

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Off-Balance-Sheet Activities (1 of 3)
Off-balance-sheet activities involve trading financial
instruments and generating income from fees and loan
sales, activities that generate profits but do not appear in
the bank balance sheets.
• Loan sales (secondary loan participation) and thereby
remove these loans from the bank assets.
• Generation of fee income. Examples:
– Servicing mortgage-backed securities
– Letter of credits (LCs) and Letter of guarantees (LGs)
– FX trades on behalf of the customers

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Off-Balance-Sheet Activities (2 of 3)
• Trading activities and risk management techniques in
attempt tp manage interest rate risks:

– Financial futures, options for debt instruments,

interest rate swaps, transactions in the foreign
exchange market.

– Principal-agent problem arises especially with the

disclosure by the employees to the public about
sensitive potential information regarding financial
securities of the corporation they work for.
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Off-Balance-Sheet Activities (3 of 3)
• Internal controls to reduce the principal-agent problem:

– Separation of trading activities and bookkeeping(

complete separation from people in charge of trading
activities from those in charge for the bookkeeping of
activities)
– Limits on exposure via:

Value-at-risk
Stress testing including scenario tests “ what if”

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