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 , 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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^ank Management
ΠThe goal behind managerial policies of a bank is
to maximize the wealth of the bank¶s
shareholders
ΠIt includes Management of liquidity, Capital
adequacy, Asset & Liability Management by the
^ank.


^alance Sheet

Œ ^ank¶s balance sheet is a list of sources of


bank funds (liabilities) and uses of these
funds (Assets).
ΠAssets = Liabilities + Equity
Π^alance sheet figures are calculated at a
particular point in time and thus represent
stock values.
^ank Assets
ΠReserves
It consists of Required Reserve & Excess Reserve
ΠCash and due from banks
Vault cash, deposits held at the Central ^ank and
other financial institutions, and cash items in the
process of collection.
ΠInvestment Securities
Securities held to earn interest and help meet liquidity
needs.
Contd..
ΠLoans
The major asset, generate the greatest amount of
income, exhibit the highest default risk and are
relatively illiquid.
ΠOther assets
^ank premises and equipment, interest receivable,
prepaid expenses, other real estate owned, and
customers' liability to the bank.

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^ank liabilities

ΠCheckable Deposits
It includes all checkable account like non- interest
bearing A/C.
ΠMoney market deposit accounts (MMDAs)
Pay market rates, but a customer is limited to no
more than six checks or automatic transfers each
month
ΠSavings and time deposits represent the bulk of
interest-bearing liabilities at banks.
^ank liabilities (continued)
ΠTwo general time deposits categories exist:
Time deposits in excess of $100,000, Negotiable
Deposits(CDs).
Small CDs, considered core deposits which tend
to be stable deposits that are typically not
withdrawn over short periods of time.
ΠDeposits held in foreign offices
^alances issued by a bank subsidiary located outside
country.
ΠPurchased liabilities, (rate-sensitive borrowings):
Federal Funds purchased
Repos
Other borrowings less than one year
^ank Accounts

Π$50 in cash increases assets


Π$50 in savings increases liabilities
Πsuppose required reserves are
10% of deposits
required reserve ratio
Πbank lends excess reserves,
II. ^ank Management
ΠLiquidity management
need cash to deal with deposit outflows
but holding cash drags down profits
Managing Liquidity
Π^anks can experience illiquidity when cash outflows
exceed cash inflows
Illiquidity can be resolved by creating additional liabilities or
selling assets
Π^anks should maintain the level of liquid assets that will
satisfy their liquidity needs but use their remaining funds
to satisfy their other objectives
Research has shown that high-performance banks are able to
maintain relatively low liquidity

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Managing Interest Rate Risk
Π^ank performance is influenced by the interest
payments earned relative to the interest paid:

Interest revenues - Interest expenses


Net interest margin 
Assets
During a period of rising interest rates, a bank¶s net interest
margin will likely decrease if its liabilities are more rate sensitive
than its assets (see next slide)
During a period of decreasing interest rates, a bank¶s net
interest margin will likely increase if its liabilities are more rate
sensitive than its assets (see next slide)

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Managing Interest Rate Risk
(cont¶d)
ΠDetermining whether to hedge interest rate risk
^anks should consider using their measurement of
interest rate risk along with their forecast of interest
rate movements to determine whether they should
hedge
Since none of the measures is perfect for all
situations, banks measure interest rate risk using
different methods

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Managing Credit Risk
Œ Most of a bank¶s funds are used either to make
loans or to purchase debt securities, which
expose the bank to credit risk
ΠTradeoff between credit risk and expected return
^ecause a bank cannot simultaneously maximize
return and minimize credit risk, it must compromise
ΠIt will select some assets that generate high returns but are
subject to a high degree of credit risk
ΠIt will select some assets that are very safe but offer a lower
rate of return
The bank attempts to earn a reasonable return and
maintain credit risk at a tolerable level

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Managing Credit Risk (cont¶d)
ΠTradeoff between credit risk and expected return
(cont¶d)
How the loan allocation decision affects return and
risk
ΠCredit cards and consumer loans offer the highest margins
above the bank¶s cost of funds
ΠCredit cards and consumer loans will experience more
defaults than other types of loans
Many banks have adopted more lenient credit standards to
generate credit card business
For banks that were too lenient, the wide spread between the
return on credit card loans and the cost of funds has been
offset by a high level of bad debt expenses

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Asset Management
Π^ank should try to create High interest
loans with less chances of default.
ΠThey should invest in securities with high
returns and low risk.
ΠThey should invest in different types of
assets in order to diversify the risk.
ΠThe bank must ensure investment in liquid
assets to avoid the problem of illiquidity.

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Capital Adequacy Management
ΠAdequacy of capital not only prevents
bank failure but also it affects the returns
for the owners.
ΠCapital Adequacy can be determined with
the help of ROA, ROE etc
ΠTrade off between Safety & Returns to
Equity holders

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Managing Market Risk
ΠMarket risk results from changes in the value of
securities due to changes in financial market
conditions such as interest rate movements,
exchange rate movements, and equity prices
As banks pursue new services related to the trading
of securities, their exposure to market risk has
increased
^anks face increased market risk because of their
increased involvement in the trading of derivatives

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Operating Risk
ΠOperating risk is the risk resulting from a
bank¶s general business operations
related to:
Information
Execution of transactions
Damaged relationships with clients
Legal issues
Regulatory issues


Managing Risk of International
Operations
ΠExchange rate risk
Some international loans contain a clause that allows
repayment in a foreign currency, allowing the
borrower to avoid exchange rate risk
Often, banks convert available funds to whatever
currency corporations want to borrow
ΠCreates an asset denominated in a foreign currency and a
liability denominated in a different currency
Œ The bank¶s profit margin is reduced if the liability currency
appreciates against the asset currency
^anks typically hedge net exposure to exchange rate
risk

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^ank Capital Management
Π^ank operations are different from other types of
firms because the majority of their assets
generate more predictable cash flows
^anks can use a much higher degree of leverage
than other types of firms
^anks must meet the minimum capital ratio required
by regulators
ΠIf a bank has too much capital, each shareholder will receive
a smaller proportion of any distributed earnings


^ank Capital Management (cont¶d)

Π^anks can reduce the required level of capital by


selling some loans in the secondary market
^anks¶ required capital is specified as a proportion of
loans
Π^anks can reduce excessive capital by
distributing a high percentage of their earnings
to shareholders
Capital management is related to dividend policy


Integrated ^ank Management
Π^ank management of assets, liabilities, and
capital is integrated
Asset growth can be achieved only if a bank obtains
the necessary funds
Growth may require an investment in fixed assets that
will require an accumulation of bank capital
An integrated management approach is necessary to
manage liquidity risk, interest rate risk, and credit risk