CHAPTER 3

BANKING AND THE MANAGEMENT OF

FINANCIAL INSTITUTIONS

1
 Introduction
 Because banking plays such a major role in
channelling funds to borrowers with productive
investment opportunities …
 this financial activity is important in ensuring that the
financial system and the economy run smoothly and
efficiently.

 They provide loans to businesses, help us the

purchase of a new car or home, and provide us
with services such as checking and savings
accounts.
2
 The Bank Balance Sheet
To understand how banking works, first
we need to examine the bank balance
sheet, a list of the bank’s assets and
liabilities.

Total Assets = Total Liabilities + Capital

3
 The Bank Balance Sheet
 a bank‘s balance sheet lists sources of bank funds
(liabilities) and uses to which they are put (assets).

 Banks obtain funds by borrowing and by issuing other

liabilities such as deposits.

 They then use these funds to acquire assets such as

securities and loans.

 Banks make profits by charging an interest rate on

their holdings of securities and loans that is higher
than the expenses on their liabilities.
4
 Liabilities
A bank acquires funds by issuing (selling)
liabilities, which are consequently also
referred to as Sources of Funds.

The funds obtained from issuing liabilities

are used to purchase Income-Earning
Assets.

5
 Liabilities
Checkable Deposits- Checkable deposits
are bank accounts that allow the owner of
the account to write checks to third parties.
Checkable deposits include all accounts
on which checks can be drawn: non-interest
bearing checking accounts (demand
deposits), interest-bearing NOW (negotiable
order of withdrawal) accounts, and money
market deposit accounts (MMDAs). 6
 Liabilities
Checkable deposits and money market
deposit accounts are payable on
demand; that is, if a depositor shows up at
the bank and requests payment by
making a withdrawal, the bank must pay
the depositor immediately.
Similarly, if a person who receives a
check written on an account from a
bank, presents that check at the bank, it
must pay the funds out immediately (or
credit them to that person‘s account).
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 Liabilities
A Checkable Deposit/ current/ checking
account is an asset for the depositor and
a liability for the bank.
They are usually the Lowest-Cost Source
of Bank Funds because depositors are
willing to forgo some interest in order to
have access to a liquid asset that can be
used to make purchases.
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 Liabilities
 The bank‘s costs of maintaining checkable
deposits include interest payments and the
costs incurred in servicing these accounts—
 processing and storing cancelled checks,
 preparing and sending out monthly statements,
 providing efficient tellers (human or otherwise),
 maintaining an impressive building and
conveniently located branches, and
 advertising and marketing to entice customers
to deposit their funds with a given bank.
9
 Liabilities
Non-transaction Deposits- Non
transaction deposits are the primary
source of bank funds.
Owners cannot write checks on non-
transaction deposits, but the interest rates
are usually higher than those on
checkable deposits.
There are two basic types of non-
transaction deposits: Savings Accounts
and Time Deposits (also called
certificates of deposit, or CDs).
10
 Liabilities
 Savings accounts the most common type of
non-transaction deposit.

 In these accounts, to which funds can be

added or from which funds can be
withdrawn at any time, transactions and
interest payments are recorded in a monthly
statement or in a small book (the passbook)
held by the owner of the account.
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 Liabilities
Time deposits have a fixed maturity
length, ranging from several months to
over five years, and have substantial
penalties for early withdrawal (the
forfeiture of several months‘ interest).
Earn higher interest rates for the
depositors, and are a more costly source
of funds for the banks.
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 Liabilities
 Borrowings- Banks obtain funds by
borrowing from the Federal Reserve System,
the Federal Home Loan banks, other banks,
and corporations.
 Borrowings from the Fed are called discount
loans (also known as advances).
 Banks also borrow reserves overnight in the
federal (fed) funds market.
13
 Liabilities
 Banks borrow funds overnight in order to have
enough deposits at the Federal Reserve to meet the
amount required by the Fed.
 (The federal funds designation is somewhat confusing,
because these loans are not made by the federal
government or by the Federal Reserve, but rather by
banks to other banks.)

 Other sources of borrowed funds are loans made to

banks by their parent companies (bank holding
companies), loan arrangements with corporations
(such as repurchase agreements) .
14
 Liabilities
 Bank Capital- The final category on the right side of
the balance sheet is bank capital, the bank‘s net
worth, which equals the difference between total
assets and liabilities.
 The funds are raised by selling new equity (stock) or
from retained earnings.
 Bank capital is a cushion against a drop in the value
of its assets, which could force the bank into
insolvency (having liabilities in excess of assets,
meaning that the bank can be forced into
liquidation).
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 Assets
A bank uses the funds that it has
acquired by issuing liabilities to purchase
Income Earning Assets.

Bank assets are thus naturally referred to

as Uses of Funds, and the interest
payments earned on them are what
enable banks to make profits.

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 Assets
 Reserves. All banks hold some of the funds
they acquire as deposits in an account at
the National Bank.
 Reserves are these deposits plus currency
that is physically held by banks (called
vault cash because it is stored in bank vaults
overnight).
 Although reserves currently do not pay any
interest, banks hold them for two reasons.
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 Assets
 First, some reserves, called Required Reserves, are
held because of reserve requirements, the
regulation that for every dollar of checkable
deposits at a bank, a certain fraction must be kept
as reserves.
 This fraction is called the required reserve ratio.
 Banks hold additional reserves, called excess
reserves, because they are the most liquid of all
bank assets and can be used by a bank to meet its
obligations when funds are withdrawn, either directly
by a depositor or indirectly when a check is written
on an account.
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 Assets
 Cash Items in Process of Collection- Suppose that
a check written on an account at another bank is
deposited in your bank and the funds for this
check have not yet been received (collected)
from the other bank.
 The check is classified as a cash item in process
of collection, and it is an asset for your bank
because it is a claim on another bank for funds
that will be paid within a few days.

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 Assets
 Deposits at Other Banks. Many small banks
hold deposits in larger banks in exchange
for a variety of services, including check
collection, foreign exchange transactions,
and help with securities purchases.
This is an aspect of a system called
correspondent banking.

 Collectively, reserves, cash items in process

of collection, and deposits at other banks
are often referred to as cash items.
20
 Assets
 Securities. A bank’s holdings of securities are an
important income-earning asset: Securities (made up
entirely of debt instruments for commercial banks,
because banks are not allowed to hold stock).

 These securities can be classified into three

categories: government and agency securities; state
and local government securities, and other securities.

 States government and agency securities are the

most liquid because they can be easily traded and
converted into cash with low transaction costs.
21
 Assets
Because of their high liquidity, short-term
government securities are called
Secondary Reserves.
State and local government securities are
desirable for banks to hold, primarily
because state and local governments
are more likely to do business with banks
that hold their securities.
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 Assets
 Loans. Banks make their profits primarily by
issuing loans.
 A loan is a liability for the individual or
corporation receiving it, but an asset for a
bank, because it provides income to the
bank.
 Loans are typically less liquid than other
assets, because they cannot be turned into
cash until the loan matures.
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 Assets
If the bank makes a one-year loan, for
example, it cannot get its funds back
until the loan comes due in one year.
Loans also have a higher probability of
default than other assets.
Because of the lack of liquidity and
higher default risk, the bank earns its
highest return on loans.
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 Assets
The largest categories of loans for
commercial banks are commercial and
industrial loans made to businesses and
real estate loans.
Commercial banks also make consumer
loans and lend to each other. The bulk of
these interbank loans are overnight loans
lent in the federal funds market.
The major difference in the balance
sheets of the various depository
institutions is primarily in the type of loan
in which they specialize.
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 Assets
 Savings and loans and mutual savings
banks, for example, specialize in
residential mortgages, while credit unions
tend to make consumer loans.
 Other Assets. The physical capital (bank
buildings, computers, and other
equipment) owned by the banks is
included in this category.
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 Basic Banking
Better to get familiar with basic banking
operations before getting in to detail
study of Assets & Liabilities management
of banks.
Banks make profits by selling liabilities
with one set of characteristics (a
particular combination of liquidity, risk,
size, and return) and using the proceeds
to buy assets with a different set of
characteristics.
This process is often referred to as Asset
Transformation.
27
 Basic Banking
 A savings deposit held by one person can
provide the funds that enable the bank to
make a mortgage loan to another person.
 The bank has, in effect, transformed the
savings deposit (an asset held by the
depositor) into a mortgage loan (an asset
held by the bank).
 Another way this process of asset
transformation is described is to say that the
bank ―borrows short and lends long‖
because it makes long-term loans and funds
them by issuing short-dated deposits.
28
 Basic Banking
 The process of transforming assets and
providing a set of services (check clearing,
record keeping, credit analysis, and so forth)
is like any other production process in a firm.

 If the bank produces desirable services at

low cost and earns substantial income on its
assets, it earns profits; if not, the bank suffers
losses.
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 Basic Banking
T-account analysis: (borrows short and
lends long)
Case 1: Deposit of Birr 100 Cash in to ABC
Bank

Assets Liabilities
Vault Cash +100 (= Checkable Deposits
Reserves) + 100

30
 Basic Banking
Case 2: Deposit of check of Birr 100 in to
ABC Bank

Assets Liabilities
Cash items in process Checkable
of collection +100 Deposits + 100

31
 Basic Banking
Case 2.1: Check deposited in ABC bank written
against an account in XYZ bank (after check
clears).

ABC Bank
Assets Liabilities
Reserves +100 Checkable deposits +100

XYZ Bank
Assets Liabilities
Reserves -100 checkable deposits -100
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 Basic Banking
 Conclusion
When a check written on an account at
one bank is deposited in another, the bank
receiving the deposit gains reserves equal
to the amount of the check, while the bank
on which the check is written sees its
reserves fall by the same amount.
Therefore, when a bank receives additional
deposits, it gains an equal amount of
reserves; when it loses deposits, it loses an
equal amount of reserves.

33
 Basic Banking
When a bank receives new deposits, its
reserves increase by the same amount.

Under a system of fractional reserve

banking, only a fraction of these reserves
need be held.

Excess reserves may be loaned by

banks.
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 Basic Banking
Bank A receives deposits of Br 1000 when
the reserve requirement is 20%.

35
 Basic Banking
Bank A creates a loan equal to its
excess reserves

36
 Basic Banking
Loan check is cashed and funds are
withdrawn from Bank A.
Bank A has converted Br 800 in excess
reserves into Br 800 of loan (converting
non-interest bearing assets in to interest
bearing assets).

37
 Basic Banking
 The bank is now making a profit because it
holds short-term liabilities such as
checkable deposits and uses the proceeds
to buy longer-term assets such as loans
with Higher Interest Rates.
 This process of asset transformation is
frequently described by saying that banks
are in the business of ―borrowing short and
lending long.‖
38
 Principles of Bank Management
After having some idea of how a bank
operates, let‘s look at how a bank
manages its assets and liabilities in order
to earn the highest possible profit.

39
 Principles of Bank Management
 The bank manager has four primary
concerns.
1. To make sure that the bank has enough
ready cash to pay its depositors when
there are deposit outflows, that is, when
deposits are lost because depositors make
withdrawals and demand payment.
o To keep enough cash on hand, the bank must
engage in liquidity management, the
acquisition of sufficiently liquid assets to meet
the bank’s obligations to depositors.
Ensuring that are sufficient liquid assets to
cover deposit outflows.
40
 Principles of Bank Management
2. The bank manager must pursue an
acceptably low level of risk by acquiring
assets that have a low rate of default and
by diversifying asset holdings (asset
management).
Maintaining low risk and high returns
Managing Credit Risk
Managing Interest rate risk
41
 Principles of Bank Management
3. To acquire funds at low cost (liability
management).
Obtaining funds at low cost
4. Finally, the manager must decide the
amount of capital the bank should maintain
and then acquire the needed capital
(capital adequacy management).
Maintaining appropriate level of bank
capital
42
 1. Liquidity Management
Case 1: enough excess reserve
Reserve requirement = 10%, Excess
reserves = 10 million

With 10% reserve requirement, bank still

has excess reserves of 1 million: no
changes needed in balance sheet
43
 1. Liquidity Management
Case 2: No excess reserves

44
 1. Liquidity Management
Case 2.1: Borrow from other banks or
corporations

Case 2.2: Sell Securities

45
 1. Liquidity Management
Case 2.3: Borrow from Fed

Case 2.4: Call in or sell off loans

Conclusion: excess reserves are

insurance against above 4 costs from
deposit outflow

46
 1. Liquidity Management
 Banks may hold excess reserves to guard
against deposit outflows and reserve
shortfalls
 A reserve shortfall may be Costly by:
– Borrowing reserves from other banks in the
federal funds market or from corporations
(repurchase agreements or negotiable CDS)
– Selling Securities (federal securities serve as
‘secondary reserves’)
– Borrowing from the Fed (discount loans)
– Calling in or sell off loans
Banks hold more excess reserves when the
cost of a reserve shortfall is higher.
47
MANAGING LIQUIDITY RISK
Sources of Liquidity Risk
a)When debt holders (depositors)
want to withdraw their financial
claim
b)Off balance sheet commitments
(loan commitments) made by FIs
are exercised
 to meet demands of short term
debt holders , FIs may at times be
compelled to liquidate assets at
fire-sale prices
48
 MANAGING LIQUIDITY RISK
Liability side liquidity risk of DIs
 arises due to holding short-term
financial obligations
 a DI has core deposit that remains
unwithdrawn over a long period of
time
 withdrawals may be offset by
attracting new deposits, and here only
the net deposit drain becomes a
concern
 a drain on deposit can be managed
through (1) purchased liquidity and (2)
stored liquidity mgt
49
MANAGING LIQUIDITY RISK

(1) Purchased Liquidity

 raising short-term funds from the
money market (Repos or interbank
loan)
 helps to keep the asset side of the
balance sheet undisturbed
 expensive when cost of the funds is
more than return on asset
50
MANAGING LIQUIDITY RISK

(2) Stored liquidity mgt

 keeping excess reserves or by
liquidating near-cash items such as
marketable securities, Loans etc

51
 Managing Liquidity Risk
Impact of purchased liquidity versus
stored liquidity.
Suppose Addis Bank has the following
condensed balance sheet:

52
 MANAGING LIQUIDITY RISK
Example...
 Addis Bank pays, on average, 5% on
core deposit and generates
average return of 8% on loans.
Increases in market interest rate are
expected to cause a net drain of Br
2mill.
 Two options are available to
manage the expected net drain:
1. Raise short-term debt at a cost of
7% (purchase liquidity)
2. Sell loans for cash (stored liquidity)
53
 MANAGING LIQUIDITY RISK

Example...
(1) Raise short-term debt at a cost of 7%
(purchase liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5% = Br 100,000
Increase in interest exp-
short-term debt Br 2mill x 7% = -140,000
Change in Net Income -Br 40,000
54
 MANAGING LIQUIDITY RISK

Example...
(2) Sell loans for cash (Store Liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5%= Br 100,000
Decrease in interest income-
loans Br 2mill x 8%= 160,000
Change in Net Income -Br 60,000
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MANAGING LIQUIDITY RISK

Asset Side Liquidity Risk

 arises when borrowers want to
exercise loan commitments made by
a bank
 such commitments obligate the bank
to satisfy loan demand by borrowers
 demand for loan can be satisfied
through either purchased liquidity or
stored liquidity
56
 MANAGING LIQUIDITY RISK
Measuring a Bank‗s liquidity exposure
(a) The net liquidity statement
Shows the sources and uses of
liquidity
Sources of liquidity include selling
near cash items, borrowing in the
money market, or using excess
reserves
Uses of liquidity include repayment of
debts.
57
 MANAGING LIQUIDITY RISK
Measuring a Bank‗s liquidity exposure

(Example)

The following information has been extracted from

records of a bank.

 Near cash items Br 100,000

 Interbank loan (Debt) 250,000

 Max borrowed funds lim 850,000

 Funds borrowed 550,000

 Excess reserve at NBE 150,000

58
MANAGING LIQUIDITY RISK
Measuring a Bank‘s liquidity exposure
The net liquidity statement
A bank can have the following sources and uses of liquidity
Sources of Liquidity:
-Near cash items Br 100,000
-max borrowed funds lim 850,000
-excess reserve 150,000
Total Br 1,100,000
Uses
- Funds borrowed Br 550,000
- Interbank loan 250,000
Total Br 800,000
Excess liquidity Br 300,000

59
MANAGING LIQUIDITY RISK

(b) Peer Group Ratio Comparison

 Comparison of the following ratios
may help
 loan to deposit
 borrowed fund to total asset
 commitments to lend to total
asset ratio

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 2. Asset Management
To maximize profit, bank seek the highest
returns, lowest risk and more liquidity in 4
ways
Try to find borrowers with low default risk
who are willing to pay high interest rates.
Purchase securities with high return and
low risk.
Diversify on both securities and loans:
‗don‘t put too many eggs in one basket‘‘
Maintain sufficient liquidity so as to satisfy
reserve requirements at low cost.
61
 3. Capital Adequacy Management
Banks must manage bank capital to:
– Help prevent bank failure,

– Help determine the rate of return to owners, and

– Meet regulatory minimum capital requirements.

Bank Capital reduces the likelihood of

bank failure (if net worth is larger and the
bank faces losses, net worth may remain
positive).
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 3. Capital Adequacy Management

Now, Suppose that there is a bad loan of $5m

for both banks, then

 Conclusion: A bank maintains bank capital to

lessen the chance that it will become insolvent
(bankrupt).
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 Return on Equity and Bank Capital
Higher is bank capital, lower is return on
equity (Capital inc, EM dec, ROE dec)
– Return on Asset (ROA) = net profit after
taxes/assets
– Return on Equity (ROE) = net profit after
taxes/equity
– Equity Multiplier = assets/Equity capital
– ROE = ROA * EM
Return on Equity is higher when bank
capital (equity capital) is low.
Tradeoff between safety (high capital)
and ROE.
64
 Changes in Bank Capital
Banks also hold capital to meet capital
requirements
If banks choose to increase bank capital
relative to assets, they may do so by:
– Issuing common stock (increasing equity)
– Reducing dividends to shareholders (adding
retained earnings to the capital account), or
– Issuing fewer loans or selling off loans or other
assets.
– And vice versa

65
 4. Managing Credit Risk
 Reducing impact of adverse selection and
moral hazard problems by: (business of
banking is production of information)
– Screening
– Specialization in lending
– Monitoring and enforcement of restrictive covenants
– Long term customer relationships
– Loan covenants (facilitates long term relationships
– Collateral and compensating balances
– Credit rationing
66
 4. Managing Credit Risk
Causes
 the problem of Information
Asymmetry
–adverse selection and moral
hazard
Credit Analysis
 the 5 C‗s (Capacity, Conditions,
Character, Capital, and Collateral)
67
 5. Managing Interest Rate Risk
ABC Bank

68
 5. Managing Interest Rate Risk
 Rate-sensitive assets (liabilities) = assets
(liabilities) with interest rates that vary
frequently
– Rate sensitive assets: Variable-rate and short-
term loans
– Rate sensitive liabilities: Variable rate CDs and
money market deposit accounts
 Fixed-rate assets (liabilities) = assets
(liabilities) with interest rate that remain
unchanged for long periods
– Fixed rate assets: reserves, long-term loans,
long-term securities
– Fixed-rate liabilities: checkable deposits,
savings deposits, long-term CDs, equity capital
69
 5. Managing Interest Rate Risk
If a bank has more rate sensitive
liabilities than assets, an increase in
interest rates will reduce its profitability.

If a bank has more rate sensitive assets

than liabilities, a decrease in interest
rates will reduce its profitability.

70
 5. Managing Interest Rate Risk
GAP analysis
 GAP = rate-sensitive assets – rate- sensitive
liabilities
= 20 – 50 = -30 million
When ‗I‘ increases by 5%
 Income on assets = 1 million (5% * 20 million)
 Costs on liabilities = 2.5 million (5% * 50 million)
 Change in profits = 1m – 2,5m = -1.5m
= 5% * (20m – 50m) = 5% * GAP

Change in Profit = Change in I * GAP

71
 Gap Analysis
Basic Gap =
Rate sensitive assets – rate sensitive liabilities
 Change in Profits = gap * change in interest rate

 Problem: not all assets and liabilities have the

same maturity

 Maturity bucket approach: measure the gap at

several maturity subintervals (maturity buckets)

 Standardized gap analysis: takes differing degrees

of rate sensitivity in to account

72
 Gap Analysis
Example: Consider the following list of
RSAs and RSLs of Addis Bank (in millions)

73
 GAP ANALYSIS
Example...
Suppose short-term interest rate increases
by 1% affecting assets and liabilities in the
first bucket.
 NII= - Br 5mill x 1%

= - Br 50,000
What would be the change in NII if the
change in short-term interest rate affects
RSAs and RSLs that can be repriced within
6months to a year?
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CHAPTER END!

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