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[Audio] Chapter 9 Banking and the Management of Financial Institutions Dr. Taghreed Hassouba Part 2.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 2 General Principles of Bank Management: • Liquidity Management (acquire enough liquid assets to meet obligations ----- deposits outflows) • Asset Management (acquire diversified assets ) • Liability Management (acquire funds at low cost) • Capital Adequacy Management (deciding the amount of capital the bank should maintain) • Credit Risk (the risk arising because borrowers may default) • Interest-rate Risk (the riskiness of earnings and returns on bank assets caused by interest rate changes).

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 3 Liquidity Management and the Role of Reserves • Excess reserves: – 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. First National Bank First National Bank Assets Liabilities Assets Liabilities Reserves $ 20M Deposits $ 100M Reserves $10M Deposits $ 90M Loans $ 80M Bank Capital $10M Loans $80M Bank Capital $ 10M Securities $10M Securities $10M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4-4 • Shortfall: • This situation is quite different as the bank holds insufficient excess reserves. Let's assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $ 10 million, so that it holds no excess reserves. • It should be clear that: • Reserves are a legal requirement and the shortfall must be eliminated. • Excess reserves are insurance against the costs associated with deposit outflows. First National Bank First National Bank Assets Liabilities Assets Liabilities Reserves $10M Deposits $ 100M Reserves $ 0 Deposits $ 90M Loans $90M Bank Capital $10M Loans $90M Bank Capital $10M Securities $10M Securities $ 10M Liquidity Management and the Role of Reserves.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 5 Liquidity Management and the Role of Reserves ( four basic options) • Option 1: Borrowing: By acquiring the reserves needed to meet a deposit outflow by borrowing them from other banks in the federal funds market, or by borrowing from corporations. If the First National Bank acquires the $ 9 million shortfall in reserves by borrowing it from other banks or corporations, its balance sheet becomes: – Cost incurred is the interest rate paid on the borrowed funds First National Bank Assets Liabilities Reserves $ 9M Deposits $ 90M Loans $90M Borrowing $9M Securities $ 10 M Bank Capital $10M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 6 • Option 2: Securities sale: • selling some of its securities to help cover the deposit outflow. For example, it might sell $ 9 million of its securities and deposit the proceeds with the Fed, resulting in the following balance sheet: – The cost of selling securities is the brokerage and other transaction costs. Liquidity Management and the Role of Reserves First National Bank Assets Liabilities Reserves $ 9M Deposits $ 90M Loans $90M Bank Capital $ 10M Securities $ 1M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 7 Liquidity Management and the Role of Reserves • Option 3: Federal Reserves: • A third option for meeting a deposit outflow: It can acquire reserves by borrowing from the Fed. In our example, the First National Bank could leave its security and loan holdings the same, and borrow $ 9 million in discount loans from the Fed. Its balance sheet would then be: – Cost are considered by the concept that borrowing from the Fed "CB" also incurs interest payments based on the discount rate. – Too much borrowing restricts borrowing in the future. First National Bank Assets Liabilities Reserves $ 9M Deposits $90M Loans $ 90M Borrowings from Fed $9M Securities $10M Bank Capital $ 10M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 8 Liquidity Management and the Role of Reserves • Option 4: Reduce Loans: • As a last option, a bank can acquire the $9 million of reserves to meet the deposit outflow by reducing its loans by this mount and depositing the $ 9 million it then receives with the Fed " CB", thereby increasing its reserves by $9 million. This transaction changes the balance sheet as follows: – Reduction of loans is the most costly way of acquiring reserves: – Calling in loans antagonizes customers. – Other banks may only agree to purchase loans at a substantial discount. First National Bank Assets Liabilities Reserves $ 9M Deposits $ 90M Loans $ 81M Bank Capital $10M Securities $ 10M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 9 The foregoing discussion explains why banks hold excess reserves even though loans or securities earn a higher return. When a deposit outflow occurs, excess reserves enable the bank to escape the costs of ( 1) borrowing from other banks or corporations, ( 2) selling securities, ( 3) borrowing from the Fed, or ( 4) calling in or selling off loans. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves a bank will want to hold..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 10 Think!!!!! • Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the CB? • Because if the bank borrows too frequently from the CB, the CB may restrict its ability to borrow in the future..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 11 Think!!!!! • If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to lend out? Why or why not? What options are available that will enable you to provide the funds your customer needs? • No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly. • Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make loans to the customer. • Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 12 1. The bank you own has the following balance sheet: Assets Liabilities Reserves $ 75 million Deposits $ 500 million Loans $ 525 million Bank capital $ 100 million If the bank suffers a deposit outflow of $ 50 million with a required reserve ratio on deposits of 10%, what actions should you take? Think!!!!!.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 13 Assets Liabilities Assets Liabilities Reserves $ 75M Deposits $ 500M Reserves $ 25M Deposits $450M Loans $ 525M Bank Capital $100M Loans $525M Bank Capital $100M The $50 million deposit outflow means that reserves fall by $ 50 million to $ 25 million. Since required reserves are $ 45 million ( 10% of the $ 450 million of deposits), your bank needs to acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off $20 million of loans, borrowing $ 20 million in discount loans from the Fed, borrowing $20 million from other banks or corporations, selling $20 million of securities, or some combination of all of these. Assets Liabilities Reserves $ 45M Deposits $ 450M Loans $ 505M Bank Capital $ 100M.

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 14 Asset Management : To maximize profits, a bank must simultaneously seek three goals: 1. Seek the highest possible returns on loans and securities. 2. Reduce risk. 3. Have adequate provisions of liquidity by holding liquid asset..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 15 Asset Management Banks accomplish these goals through four tools: 1. Find borrowers who will pay high interest rates and have low possibility of defaulting. 2. Purchase securities with high returns and low risk. 3. Seeking to be at lower risk by diversifying both assets (short and long term) and approving different types of loans from different customers. 4. Finally, the bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy its reserve requirements without bearing huge costs, then it should balance need for liquidity against benefits of the increased returns from less liquid assets ..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 16 Think!!!!! • " Bank managers should always seek the highest return possible on their assets." Is this statement true, false, or uncertain? Explain your answer. • False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. • Thus a bank manager has to consider risk as well as the expected return when deciding to hold an asset..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 17 Liability Management : • In the past banks took their liabilities as fixed. • Liability management is a recent phenomenon due to rise of money center banks. • large banks are (called money center banks) which began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity. • This move led to expansion of overnight loan markets and development of new financial instruments (such as negotiable CDs) • The greater emphasis on liability management explains some of the important changes over the previous period in the composition of banks' balance sheets. While negotiable CDs and bank borrowings have greatly increased in importance as a source of bank funds in recent years , we found that Checkable deposits have decreased in importance as source of bank funds..

[Audio] © 2016 Pearson Education, Inc. All rights reserved. 4- 18 END OF LECTURE J.