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[Audio] Chapter 9 Banking and the Management of Financial Institutions Dr. Taghreed Hassouba Part 3.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 2 Capital Adequacy Management: • Bank capital helps prevent bank failure : a situation in which the bank cannot satisfy its obligations to pay its depositors and other creditors, and so goes out of business. • The amount of capital affects return for the owners ( equity holders) of the bank. • Regulatory requirement : minimum amount of bank capital ( bank capital requirements) is required by regulatory authorities..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 3 •How Bank Capital Helps Prevent Bank Failure : •Let's consider two banks with identical balance sheets, except that High Capital Bank has a ratio of capital to assets of 10% , while Low Capital Bank has a ratio of 4%: Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 4 •How Bank Capital Helps Prevent Bank Failure: •Suppose both banks lose $ 5 million of their housing loans and now these 5$ million have become worthless. •Then , the total value of assets declines by $5 million. •As a consequence, bank capital, which equals total assets minus liabilities, also declines by $5 million. •The balance sheets of the two banks now look like this: Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 5 Capital Adequacy Management: High Capital Bank : its initial cushion of $ 10 million in capital , then it means that it still has a positive net worth ( bank capital) of $ 5 million after the loss. Low Capital Bank, however, is in big trouble. The value of its assets has fallen below that of its liabilities, and its net worth is now – $ 1 million. Because the bank has a negative net worth, it is insolvent: It does not have sufficient assets to pay off all holders of its liabilities..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 6 Capital Adequacy Management: Since Low Capital Bank has negative net worth: government regulators close the bank, its assets are sold off, and its managers are fired. Because the owners of Low Capital Bank will find their investment wiped out, they clearly would have preferred the bank to have had a large enough cushion of bank capital to absorb the losses, as was the case for High Capital Bank. - We therefore see an important rationale for a bank to maintain a sufficient level of capital: A bank maintains bank capital to lessen the chance that it will become insolvent..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 7 How the Amount of Bank Capital Affects Returns to Equity Holders: Because owners of a bank must know whether their bank is being managed well, they need good measures of bank profitability : •A basic measure of bank profitability is the return on assets (ROA), the net profit after taxes per dollar of assets: ROA = Net profit after taxes /Total assets •The return on assets provides information on how efficiently a bank is being run because it indicates how much profit is generated, on average, by each dollar of assets. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 8 How the Amount of Bank Capital Affects Returns to Equity Holders: •However, what the bank's owners ( equity holders) care about most is how much the bank is earning on their equity investment. •This information is provided by the other basic measure of bank profitability, the return on equity ( ROE), which is defined as the net profit after taxes per dollar of equity (bank) capital: ROE = Net profit after taxes / equity capital • The return on assets provides information how much profit is generated, on average, by each dollar of equity. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 9 How the Amount of Bank Capital Affects Returns to Equity Holders: •There is a direct relationship between the ROA and ROE ,This relationship is determined by the equity multiplier ( EM), or the amount of assets per dollar of equity capital: EM = assets / equity capital •To see this, we note that : Net profit after taxes /equity capital = (Net profit after taxes /Total Assets)* (Total assets /equity capital) •which, using our definitions, yields : ROE = ROA * EM •The formula in the previous Equation tells us what happens to the return on equity when a bank holds a smaller amount of capital (equity) for a given amount of assets. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 10 Return on Assets: net profit after taxes per dollar of assets ROA = net profit after taxes assets Return on Equity: net profit after taxes per dollar of equity capital ROE = net profit after taxes equity capital Relationship between ROA and ROE is expressed by the Equity Multiplier: the amount of assets per dollar of equity capital EM = Assets Equity Capital net profit after taxes equity capital = net profit after taxes assets ´ assets equity capital ROE = ROA ´ EM How the Amount of Bank Capital Affects Returns to Equity Holders: Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 11 How the Amount of Bank Capital Affects Returns to Equity Holders: ROE = ROA * EM • High Capital Bank initially has $100 million of assets and $10 million of equity, which gives it an EM of 10 (= $100 million>$ 10 million). •Low Capital Bank, by contrast, has only $4 million of equity, so its equity multiplier is higher, equaling 25 (= $ 100 million > $ 4 million). •Suppose these banks have been equally well run, so that they both have the same ROA, 1%. •The ROE for High Capital Bank equals 1% * 10 = 10%, whereas ROE for Low Capital Bank equals 1% * 25 = 25%. •The equity holders in Low Capital Bank are clearly a lot happier than the equity holders in High Capital Bank because they are earning more than twice as high a return. • Now we see why the owners of a bank may not want it to hold too much capital that is because : Given the return on assets, the lower the bank capital, the higher the return for the owners of the bank. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 12 Trade-off between safety and returns to equity holders: • The bank capital has both benefits and costs. • Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. • But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. • In determining The optimal amount of bank capital, managers must compare the benefit of maintaining higher capital (increased safety) with the cost of higher capital (the lower return on equity for bank owners). • At the end , Choice definitely depends on the state of the economy and levels of confidence. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 13 • BANK CAPITAL REQUIREMENTS: • Banks hold capital because they are required to do so by regulatory authorities. • Because of the high costs of holding capital, bank managers often want to hold less bank capital relative to assets than is required by the regulatory authorities. • In this case, the amount of bank capital is determined by the bank capital requirements. Capital Adequacy Management:.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 14 If a bank finds that its ROE is too low because it has too much bank capital , what can it do to raise its ROE ? • To lower capital and raise ROE , holding its assets constant, it can : Ø pay out more dividends. Ø buy back some of its shares. • Or it can keep its capital constant , but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds ( expansion in lending). Strategies for Managing bank capital :.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 15 Strategies for Managing bank capital: If the bank faced by shortfall in bank capital, and it wants now to increase the amount of capital relative to assets (Decrease EM) to overcome this problem: • To increase capital, holding its assets constant, it can : Ø reduce the bank dividends to stockholders.(Increase retained earnings) Ø Issue new shares and equity. • Or it can keep its capital constant , but reduce the amount of its assets by cutting back lending and to tighten their lending standards. • Our analysis explain how shortfalls of bank capital led to slower credit growth..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 16 Class Activity • If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its ROE? • To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. • Alternatively, it can keep its capital constant, but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 17 Class Activity • If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do to rectify the situation? • It can raise $1 million of capital by issuing new stock. • It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $ 1 million. • It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 18 Class Activity • Why do equity holders care more about ROE than about ROA? • Because ROE, the return on equity, tells stock holders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank's assets are being managed..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 19 Class Activity • If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE? • ROE will fall in half..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 20 Class Activity • X-Bank reported an ROE of 16% and an ROA of 1.32%. What is the equity multiplier? • The equity multiplier is ROE/ROA. • The equity multiplier is approximately 12.12% . • This is a well-capitalized bank because its equity asset ratio exceeds the minimum required level..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 21 Class Activity • If the president of a bank told you that the bank was so well run that it has never had to call in loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in that bank? Why or why not? • No, because the bank president is not managing the bank well. • The fact that the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. • Thus the bank's profits are low, and stock in the bank is not a good investment..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 22 Managing Credit Risk : Credit risk: • It is defined the risk arising because borrowers may default.(They are unable to pay the loan). • To manage credit risk the bank must deal with asymmetric information problems. • The economic concepts of adverse selection and moral hazard provide a framework for understanding the principles that financial institutions must follow if they are to reduce credit risk and make successful loans..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 23 Managing Credit Risk : • Adverse selection in loan markets occurs because bad credit risks (those most likely to default on their loans) are the ones who usually line up for loans; in other words, those who are most likely to produce an adverse outcome are also the most likely to be selected. • Moral hazard exists in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lender's point of view. • To be profitable, financial institutions must overcome the adverse selection and moral hazard problems that make loan defaults more likely. • To sum up , principles are followed to Control Default & asymmetric Information..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 24 Screening and Monitoring: • Asymmetric information is present in loan markets because lenders have less information about the investment opportunities and activities of borrowers than borrowers do. • Screening : collect reliable information about the potential borrower to evaluate its level of credit risk. • This is done through filling out a form based on it the bank officer calculating borrower's credit score and deriving a statistical measure from the answers to predict whether the borrower is more likely to have trouble making the loan payments. • The process of screening and collecting information is done to personal finances as well as business loans. Managing Credit Risk :.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 25 - Specialization in lending ( location – activity) : One puzzling feature of bank lending is that a bank often specializes in lending to local firms or to firms in particular industries. In one sense, this behavior seems surprising because it means that the bank is not diversifying its portfolio of loans and thus is exposing itself to more risk. From other perspective : It makes perfect sense because the bank develops expertise in collecting information about this specialized activities . The bank becomes more able to handle asymmetric information problems. The bank becomes more knowledgeable about these industries and is therefore better able to predict which firms will be able to make timely payments on their debt. It improves its ability in screening and monitoring. Managing Credit Risk :.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 26 – Monitoring and enforcement of restrictive covenants : - To reduce moral hazard bank must write restrictive covenants in the loan contract to restrict borrowers from engaging in risky activities. - By monitoring borrowers' activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they are not, lenders can make sure that borrowers are not taking on risks at their expense. - To sum up , The need for banks and other financial institutions to engage in screening and monitoring explains why they spend so much money on auditing and informationcollecting activities. Managing Credit Risk :.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 27 Class Activity • "Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is this statement true, false, or uncertain? Explain your answer. • False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. • For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 28 END OF LECTURE J.