Chapter 12: Depository Institutions: Banks and Bank Management

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A bank is a firm, and with the exception of credit unions, they are for-profit institutions. As depository institutions there are unique issues regarding the management of these firms. In this chapter we study the management of bank balance sheets as well as the management of the risks inherent in the assets and liabilities of bank balance sheets.
The Bank Balance Sheet
Banks are a financial intermediary, taking the funds of depositors and turning into loans in their primary business. This process is one of asset transformation: the assets of a persons savings deposit are converted to a home loan, which is a bank assets, and the bank creates liabilities in the process. We will see this with a look at a banks balance sheet. A summary of almost 8000 commercial bank balance sheets for August 2004 is on page 288.
A bank's balance sheet is simply a list of a bank's assets and liabilities where
total assets = total liabilities + capital.
Assets
Assets are a bank's uses of funds.

• Reserves. All banks must hold some funds to satisfy the withdrawals of their depositors (known as vault cash), and they are also required to hold some funds in deposits at the Fed. The some of these holdings are the bank's reserves. Some of the reserves arerequired reserves that much be held by law. This requirement is set by the Fed as a percentage of deposits and is called therequired reserve ratio. The remaining are excess reserves held to satisfy depositor withdrawals.
• Cash items in process of collection include funds being transferred from one bank to another, mostly due to check writing and depositing between different banks.
• Banks often have deposits at other larger banks for check clearing and exchanging foreign currency.
• Securities. Banks hold securities as a source of income (and profit). Bank's security holding are only debt securities as they are not allowed to hold stock. Banks hold a large amount of U.S. government debt due to its high liquidity and low risk. This type of debt can be sold quickly to raise cash, so they act as secondary reserves. Banks also hold municipal debt for its tax advantages and to gain the business of those municipalities.
• Loans. Over 60% of a commercial banks assets are loans. Categories include commercial lending, real estate lending, consumer loans, and interbank loans. Specific institutions will often specialize in a category of lending. Loans are significantly less liquid than securities and often have a higher default risk.

Liabilities
Liabilities are a bank's sources of funds. Over 60% of the funds for commercial banks come from deposits.

• Checkable deposits include basic checking accounts that earn no interest, along with other interest-bearing checking accounts (NOW accounts and money market accounts). The low or zero interest on these accounts make them a cheap source of funds, but they are also expensive for banks to service as well. These types of deposits have declined proportionally as a bank liability as people have turned to other alternatives from nondepository institutions, namely money market mutual funds.
• Nontransaction deposits are the most important source of bank funds. The pay higher interest but have no check-writing privileges. Savings deposits, small time deposits and large time deposits are all in this category.

In addition to deposits, banks also obtain funds from borrowing. Borrowed funds include

• Discount loans from the Federal Reserve system
• Federal funds, which are loans from other banks
• Repos, which are asset repurchase agreements from corporations
• Eurodollar loans from foreign banks
• Commercial paper issued by the bank holding company.

Bank Capital
Bank capital refers to the bank's net worth or assets minus liabilities. This capital provides a safety net in case some of the banks assets fall in value, so the bank can still meet it obligations to the depositors and creditors. One important component of bank capital is loan loss reserves, specifically set aside to cover defaulted loans. Note that in the bank balance sheet on page 288, bank capital is $700 billion on $7.2 trillion of liabilities. This is a leverage of 10 to 1--a bank borrows $10 for every $1 in capital. This degree of leverage is far greater than U.S. households or even other nonfinancial businesses. As we will see in the next chapters, government guarantees enable banks to get away with this high degree of leverage and the risk it entails.
Banks also must make decisions about capital. Capital provides protection for the bank from bad loans or securities. Without it, any loss in asset value could lead to insolvency for the bank. However, lower bank capital will increase the return to the banks shareholders (the ROE, equation 3, 296). So the bank faces a tradeoff between safety and the returns to the bank's owners. Because of this conflict, federal regulators set minimum capital requirements for banks, as a percentage of risk-adjusted assets.
Bank Risks
The leverage in the banking industry, along with the unique deposit-taking features of its business, expose the industry to a variety of risks.
Liquidity Risk
But how does a bank decide how much to lend and how much to keep as excess reserves? This is the key issue in liquidity management, where bank managers must decide the amount of liquidity necessary to deal with deposit outflows. The tradeoff here is this: Reserves earn no interest, so too much excess reserves will drag down profits. However, if the bank holds insufficient cash to meet deposit outflows, then it must raise additional cash by

• borrowing from other banks in the federal funds market, incurring borrowing costs
• borrowing from the Fed, which could increase regulatory scrutiny as well as incur borrowing costs
• selling securities, which incurs trading costs
• call in some existing loans and risk alienating bank loan customers
• or sell some existing loans, typically at a steep discount.

All of these options are costly in some way. So banks will hold some excess reserves to reduce the probability of having to raise additional cash quickly. The amount of excess reserves will depend on the costs of raising cash as well as the expected deposit outflows. This will also affect the amount of secondary reserves the bank chooses to hold.
In managing the asset side of the balance sheet a bank has several goals:

• maximize returns (and profits)
• minimize risk
• adequate liquidity
• regulatory compliance

Again, these goals involve tradeoffs. If a bank is too conservative with respect to risk and liquidity (choosing assets with only high liquidity and low risk), then asset returns may be too low to return a profit. Banks that take on too much risk and incur loan defaults could end up insolvent, with the value of assets too low to satisfy all liabilities.
Liability management has taken on more importance in the last 30 years as banks have facing increasing competition from other financial institutions with new financial instruments and as financial markets opened up new alternatives for banks to raise funds. Large banks, known as money center banks, raise funds through avenues other than deposits, including commercial paper markets, CD markets, and the federal funds market.
Credit Risk
The previous discussions about asset and capital management highlight the importance of managing credit risk (or default risk) for banks. As loans are the primary asset for commercial banks, the problems of adverse selection and moral hazard come into play. A bank must deal with these problems in order to minimize its credit risk.
Recall from chapter 11 that adverse selection occurs BEFORE the loan is made, in that individuals that engage in risky behavior or more likely to want to borrow money in the first place. Moral hazard occurs AFTER the loan as an individual may "blow" the money and not be able to repay it. Also described in chapter 11 are the variety of ways banks deal with these problems: screening, collateral, monitoring to name a few.
One key to risk reduction is diversification. By holding the debt and loans of many different borrowers, a bank can reduce default risk without sacrificing too much return. Too often banks have specialized in lend to one industry, like agriculture or oil, and have suffered losses when those industries hit hard times.
Interest Rate Risk
Both a bank' assets and liabilities are sensitive to changes in market interest rates. For assets, changes in interest rates affects the VALUE of assets, but also the interest INCOME they generate in different ways. Long-term assets, such as long-term securities and loans generate income that is not sensitive to interest rate changes (although their VALUE is very sensitive). However short-term assets such as federal funds, variable-rate loans, or short-term loans and securities generate income that fluctuates with market interest rates.
On the liability side, the cost of acquiring funds (the interest paid by banks) goes up with interest rates, especially for money market accounts and short-term CDs. The cost is more stable for long-term CDs, checking deposits, and savings deposits.
So when interest rates rise, the cost of liabilities goes up, but the income from assets go up as well. The total effect on bank profits will depend on whether the rate-sensitive assets outnumber the rate-sensitive liabilities. In most cases, banks have many more rate-sensitive liabilities than assets, so rising interest rates may result in falling profits. This is because banks typically borrow short-term and lend long-term, a function known as maturity intermediation.
As interest rates have become more volatile in the past 30 years, banks have taken measure to manage their interest rate risk using derivative securities, which we discussed in Chapter 9.
Trading Risk
Risk management has become an essential part of overall bank management. However managing these risks involves the trading of derivative assets that introduce new risks. Traders working on behalf of banks are able to bet large sums of money without being responsible for covering losses. This introduces what economists refer to as the principal-agent problem. The principle (the bank) and the agent (the trader) may have different objectives so that the trader does not always operate in the bank's best interest. An example of the disastrous effects of rouge traders is discussed on page 308.
Other Bank Activities
Banks increasingly generate revenue through activities not on the balance sheet. These activities are a growing source of bank profitability.

• Loan sales have risen with the growth of a secondary loan market. Instead of remaining on the balance sheet until paid, banks sell loans or just the right to the loan payments to third parties. If these loans carry higher interest rates than the current market, they will sell at a premium. If the loans carry lower interest rates, they will sell at a discount. Either way, a loan sale will free up funds for the bank to make additional loans.
• Fee income has increased in importance in its contribution to bank profits. These include ATM fees, account service fees, fees for servicing loans after their sale, and fees for more specializing lending services. Banks also receive fees for guaranteeing securities against default, acting as a co-signer with a debt issuer. As banks increasingly face competition from other finance companies for the loan market, this has interest-rate margins, and thus profits down. Fee income has helped increase profitability in the 1990s.

All of these off-balance-sheet activities create other areas for bank regulators to scrutinize. While some of these activities are designed to manage the risk inherent in traditional banking activities, they also introduce new risks that can potentially destabilize the banking system.
FYI: Related Links
Multiple Choice Quiz Chapter 12 An interactive quiz from the Mishkin textbook website.
The Federal Depository Insurance Corporation (FDIC) Take a close look at this important regulator of depository institutions.
Risk management for banks and bank regulators in the 21st century This is a 1997 speech by Federal Reserve Governor Susan Phillips about the changes in risk management by banks in the past 10 years.

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