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Banking and the Management of Financial Institutions

Q: What is asset transformation, what is maturity transformation?

Trough the process of asset transformation is how banks earn profit: They borrow short (accept deposits) and lend long (make loans). When a bank takes in additional deposits, it gains an equal amount of reserves; when it pays out deposits, it loses an equal amount of reserves. Maturity transformation: Recognising that depositors withdraw their funds at different times means that banks only need to hold a certain amount as receivers to meet day-to-day withdrawal and lend the rest in long-term loans Banks can thus accept short maturity deposits and convert them to long term loans..

16 important questions on Banking and the Management of Financial Institutions

The balance sheet of a commercial bank can be thought of a a list of sources and uses of bank funds. name 5 liabilities and 5 assets:

Liabilities

sight deposits (directly withdrawal)
time deposits (fixed term to maturity)
loans form the central bank
borrowings form other banks and corporations
bank capital

Assets:

reserves
cash in process of collection
deposits at other banks
securities
loans
Other assets (mostly physical)

What is asset transformation, what is maturity transformation?

Trough the process of asset transformation is how banks earn profit: They borrow short (accept deposits) and lend long (make loans). When a bank takes in additional deposits, it gains an equal amount of reserves; when it pays out deposits, it loses an equal amount of reserves.

Maturity transformation: Recognising that depositors withdraw their funds at different times means that banks only need to hold a certain amount as receivers to meet day-to-day withdrawal and lend the rest in long-term loans Banks can thus accept short maturity deposits and convert them to long term loans..

Bank loan officers evaluate potential borrowers using what are called the 5 C's:

Character
capacity (ability to repay)
collateral
conditions ( in the local and euro economies)
capital (net worth)

What are the four primary concerns of a bank manager?

liquidity management (enough ready cash to pay deposit outflows)
asset management (operating under acceptable risk levels)
liability management (acquire funds at low costs)
capital adequacy management (maintain sufficient capital)

If a bank has ample receivers, a deposit outflow does not necessitate changes in other parts of its balance sheet. But if they don't have ample reserves and an deposit outflow, what can they do (4)

borrowing from other banks or corporations
sell some securities
borrowing from the central bank
reducing its loans and depositing the amount with the central bank (very costly because the consequences is customers leaving)

Excess receivers are insurance against the costs associated with deposit outflows. The higher the cost associated with deposit outflows, the more excess reserves banks will want to hold.

To maximize profits, a bank must simultaneously seethe highest returns possible on loans, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Name four basic ways how banks achieve these 3 goals:

banks will try to find borrowers who will pay high interest rates and are unlikely to default on their loans
Banks try to purchase securities with high returns and low risk
banks must attempt to lower risk by diversifying
Banks must mangage the liquid it of its assets so that it can satisfy its reserve requirements without bearing huge costs.

Why did banks primarily focus on asset management? (2) How come liability management evolved?

majority of sources of banks funds were obtained with sight (demand) deposits that by law could not pay interest (thus no competition amongst banks)
interbank market was not well developed

With the development of the interbank market, banks no longer treated there liabilities as given.

Banks need to make decisions about the amount of capital they need to hold for three reasons:

bank capital helps prevent bank failure
the amount of capital affect returns for the owners (equity holders) of the bank
a minimum amount of bank capital ( bank capital requirements) is required by regulatory authorities

ROE = ROA X EM

ROE = ROA X EM (EM=Equity multiplier)

Net profit after taxes Net profit after taxes assets
------------------- = --------------------- X -------------
equity capital assets equity capital

Is there a trade off between capital adequacy an ROE?

Mishin says that in determining the amount of bank capital, managers must decide how much of the increased safety that comes with higher capital (benefits) they are willing to trade off against the lower return on equity that comes with the higher capital (the costs) --> see paper

How can you raise bank capital?

Lower the assets
Issue equity (common shares)
decrease dividends

Name 6 ways banks try to overcome the adverse selection and moral hazard problem that make loan defaults more likely:

Screening and monitoring (Screening, specialisation in lending, monitoring and restrictive covenants)
Long-term customer relationships
Loan commitments (a banks commitment to provide a loan)
collateral and compensation balances
Credit rationing (refusing to pay loans even if borrowers are willing to pay the stated interest)

Why do banks ration credit instead of charging higher rates?

The answers lies in adverse selection. Individuals at firms with high interest rates are exactly the ones willing to pay the highest interest rates. Thus charging higher rates makes adverse selection worse.

Why do banks ration credit by providing borrowers with smaller loans than they need? Why not supply the market with the loans demanded?

The answer lies in moral hazard, the larger the loan the greater moral hazard.. Because borrowers repay their loans if they are small (Less inceptive to excessive risk taking since they might need loans in the future) banks ration credit

With the increased volatility of interest rates that occurred in the 1980s, financial institutions became more concerned about their exposure to interest rate risk.
What do GAP and Duration analyses tell a finical institution?
How can financial institutions manage their interest rate risk?

GAP and Duration analyses tell a financial institution if it has more rate-sensitive liabilities than assets (in which case a rise in interest rates will reduce profits).
Financial institutions manage their interest rate risk by modifying there balance sheets but can also use strategies involving derivatives

What are types of off balance sheet activities? Do they increase risk?

Off balance sheet activities consist of trending financial instruments and generating income for fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets.

Loan sales (secondary loan participation)
Generating income form fees (making foreign exchange trades, servicing mortgage backed securities by collecting interest, guaranteeing debt securities

Because these off-balance sheet activities expose banks to increased risk, bank management must pay particular attention to risk assessment procedures and internal controls to restrict employees form taking to much risk

The question on the page originate from the summary of the following study material:

The economics of money, banking, and financial markets | 9780321599797 | Frederic Mishkin

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Banking and the Management of Financial Institutions

16 important questions on Banking and the Management of Financial Institutions

The balance sheet of a commercial bank can be thought of a a list of sources and uses of bank funds. name 5 liabilities and 5 assets:

What is asset transformation, what is maturity transformation?

Bank loan officers evaluate potential borrowers using what are called the 5 C's:

What are the four primary concerns of a bank manager?

If a bank has ample receivers, a deposit outflow does not necessitate changes in other parts of its balance sheet. But if they don't have ample reserves and an deposit outflow, what can they do (4)

To maximize profits, a bank must simultaneously seethe highest returns possible on loans, reduce risk, and make adequate provisions for liquidity by holding liquid assets. Name four basic ways how banks achieve these 3 goals:

Why did banks primarily focus on asset management? (2) How come liability management evolved?

Banks need to make decisions about the amount of capital they need to hold for three reasons:

ROE = ROA X EM

Is there a trade off between capital adequacy an ROE?

How can you raise bank capital?

Name 6 ways banks try to overcome the adverse selection and moral hazard problem that make loan defaults more likely:

Why do banks ration credit instead of charging higher rates?

Why do banks ration credit by providing borrowers with smaller loans than they need? Why not supply the market with the loans demanded?

With the increased volatility of interest rates that occurred in the 1980s, financial institutions became more concerned about their exposure to interest rate risk. What do GAP and Duration analyses tell a finical institution? How can financial institutions manage their interest rate risk?

What are types of off balance sheet activities? Do they increase risk?

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With the increased volatility of interest rates that occurred in the 1980s, financial institutions became more concerned about their exposure to interest rate risk.
What do GAP and Duration analyses tell a finical institution?
How can financial institutions manage their interest rate risk?