Text book Problems
19 Bank Management
CHAPTER OBJECTIVES
The specific objectives of this chapter are to:
· ▪ describe the underlying goal, strategy, and governance of banks,
· ▪ explain how banks manage liquidity,
· ▪ explain how banks manage interest rate risk,
· ▪ explain how banks manage credit risk, and
· ▪ explain integrated bank management.
The performance of any commercial bank depends on the management of the bank's assets, liabilities, and capital. Increased competition has made efficient management essential for survival.
19-1 BANK GOALS, STRATEGY, AND GOVERNANCE
The underlying goal behind the managerial policies of a bank is to maximize the wealth of the bank's shareholders. Thus, bank managers should make decisions that maximize the price of the bank's stock. However, bank managers may make decisions that serve their own goals rather than the preferences of shareholders. For example, if they receive a fixed salary without a bonus, they may prefer to make very conservative decisions that avoid the risk of failure. In this way, they may secure their existing job position for a long-term period. Bank shareholders might prefer that bank managers take some risk in order to strive for higher returns, and this may justify why bank manager compensation is typically tied to a measure of performance such as earnings.
19-1a Aligning Managerial Compensation with Bank Goals
In order to ensure that managers serve shareholder interests, banks commonly implement compensation programs that provide bonuses to high-level managers that satisfy bank goals. For example, managerial compensation may include stock options, which encourage managers to serve shareholders because they become shareholders. However, this might encourage bank managers to forgo the development of some long-term projects in order to focus more exclusively on increasing the current stock price in order to achieve a high bonus. Compensation programs that provide stock options are thus more effective (in terms of realizing the bank's goals) when managers are required to hold their stock for several years before selling it.
Banks have been criticized for implementing compensation programs that are overly generous and that do not necessarily align compensation with long-term performance. Many compensation programs of banks are based on existing compensation programs used by other banks. It is difficult to correct for deficiencies in compensation programs when they are fairly standard across the industry.
Some compensation programs could cause bank managers to take excessive risk, especially if the bonus would be very high when the bank's earnings are very high. They may be more willing to take excessive risk if they believe that the government will rescue them under conditions in which their risky strategies result in large losses. In this case, they earn large bonuses if their risky strategies are successful and expect to be rescued if their strategies are not successful, so they have little to lose by taking risks.
19-1b Bank Strategy
A bank's strategy involves the management of its sources of funds (liabilities) and its uses of funds (assets). Its managerial decisions will affect its performance, as measured by its income statement, in the following ways. First, a bank's decisions on sources of funds will heavily influence its interest expenses on the income statement. Second, its asset structure will strongly influence its interest revenue on the income statement. The bank's asset structure also affects its expenses; for example, an emphasis on commercial loans will result in a high labor cost for assessing loan applicants.
A bank must also manage the operating risk that results from its general business operations. Specifically, banks face risk related to information (sorting, processing, transmitting through technology), execution of transactions, damaged relationships with clients, legal issues (lawsuits by employees and customers), and regulatory issues (increased costs due to new compliance requirements or penalties due to lack of compliance).
How Financial Markets Facilitate the Bank's Strategy To implement their strategy, commercial banks rely heavily on financial markets, as explained in Exhibit 19.1. They rely on the money markets to obtain funds, on the mortgage and bond markets to use some of their funds, and on the futures, options, and swaps markets to hedge their risk (as explained in this chapter).
19-1c Bank Governance by the Board of Directors
A bank's board of directors oversees the operations of the bank and attempts to ensure that managerial decisions are in the best interests of the shareholders. Bank boards tend to have more directors and a higher percentage of outside directors than do boards of other types of firms. Some of the more important functions of bank directors are to:
· ▪ Determine a compensation system for the bank's executives
· ▪ Ensure proper disclosure of the bank's financial condition and performance to investors
· ▪ Oversee growth strategies such as acquisitions
· ▪ Oversee policies for changing the capital structure, including decisions to raise capital or to engage in stock repurchases
· ▪ Assess the bank's performance and ensure that corrective action is taken if the performance is weak because of poor management
Exhibit 19.1 Participation of Commercial Banks in Financial Markets
|
FINANCIAL MARKET |
PARTICIPATION BY COMMERCIAL BANKS |
|
Money markets |
As banks offer deposits, they must compete with other financial institutions in the money market along with the Treasury to obtain short-term funds. They serve households that wish to invest funds for short-term periods. |
|
Mortgage markets |
Some banks offer mortgage loans on homes and commercial property and therefore provide financing in the mortgage market. |
|
Bond markets |
Commercial banks purchase bonds issued by corporations, the Treasury, and municipalities. |
|
Futures markets |
Commercial banks take positions in futures to hedge interest rate risk. |
|
Options markets |
Commercial banks take positions in options on futures to hedge interest rate risk. |
|
Swaps markets |
Commercial banks engage in interest rate swaps to hedge interest rate risk. |
Bank directors are liable if they do not fulfill their duties. The Sarbanes-Oxley (SOX) Act, described in the previous chapter, has had a major effect on the monitoring conducted by board members of commercial banks. Recall that this act requires publicly traded firms to implement a more thorough internal control process to ensure more accurate financial reporting to shareholders. As a result of SOX, directors are now held more accountable for their oversight because the internal process requires them to document their assessment and opinion of key decisions made by the bank's executives. Furthermore, directors more frequently hire outside legal and financial advisers to aid in assessing key decisions (such as acquisitions) by bank executives to determine whether the decisions are justified.
Inside versus Outside Directors Board members who are also managers of the bank (called inside directors) may sometimes face a conflict of interests because their decisions as board members may affect their jobs as managers. Outside directors (directors who are not managers) are generally expected to be more effective at overseeing a bank: they do not face a conflict of interests in serving shareholders.
19-1d Other Forms of Bank Governance
In addition to the board of directors, publicly traded banks are subject to potential shareholder activism. In particular, institutional investors holding a relatively large amount of shares can attempt to influence the approach taken by the bank's managers. Shareholders may also pursue proxy contests if they want to change the composition of the board, and they can pursue lawsuits if they believe that the board is not serving shareholder interests.
The market for corporate control serves as an additional form of governance over publicly traded banks, since a bank that performs poorly may be subject to a takeover. To the extent that a bank's management serves its own rather than shareholder interests, the bank's prevailing stock valuation may be low, which could encourage another bank to acquire it. The market for corporate control serves as a form of governance because bank managers recognize that they could lose their jobs if their bank is acquired.
19-2 MANAGING LIQUIDITY
Healthy banks tend to have easy access to liquidity. However, banks can experience illiquidity when cash outflows (due to deposit withdrawals, loans, etc.) exceed cash inflows (new deposits, loan repayments, etc.). Bank liquidity problems are typically preceded by other financial problems such as major defaults on their loans. A bank that is performing poorly has less ability to obtain short-term funds because it may not be able to repay the credit that it desires. Banks can resolve liquidity problems with proper management of their liabilities or their assets.
19-2a Management of Liabilities
Banks have access to various forms of borrowing, such as the federal funds market. The decision regarding how to obtain funds depends on the situation. If the need for funds is temporary, an increase in short-term liabilities (from the federal funds market) may be appropriate. If the need is permanent, however, then a policy for increasing deposits or selling liquid assets may be appropriate.
Some banks may borrow frequently by issuing short-term securities such as commercial paper, especially when short-term interest rates are low. They may use this strategy as a form of long-term financing, as the proceeds received from each new issuance of commercial paper is used to repay the principal owed as a result of the previous issuance. However, this strategy is dangerous because if economic conditions deteriorate, causing bank loan defaults to increase, banks may no longer be able to obtain funds by issuing commercial paper. Some banks have experienced liquidity problems because they were cut off from their short-term funding sources once weak economic conditions caused their assets to appear risky.
19-2b Management of Money Market Securities
Because some assets are more marketable than others, the bank's asset composition can affect its degree of liquidity. At an extreme, banks can ensure sufficient liquidity by using most of their funds to purchase short-term Treasury securities or other money market securities. Banks could easily sell their holdings of these securities at any time in order to obtain cash. However, banks must also be concerned with achieving a reasonable return on their assets, which often conflicts with the liquidity objective. Although short-term Treasury securities are liquid, their yield is low relative to bank loans or investments in other securities. In fact, the return that banks earn on short-term Treasury securities might be lower than the interest rate they pay on deposits. Banks should maintain the level of liquid assets (such as money market securities) that will satisfy their liquidity needs but use their remaining assets to earn a higher return.
19-2c Management of Loans
Since the secondary market for loans has become active, banks can attempt to satisfy their liquidity needs with a higher proportion of loans while striving for higher profitability. However, loans are not as liquid as money market securities. Banks may be unable to sell their loans when economic conditions weaken, because many other banks may be attempting to sell loans as well, and very few financial institutions will be willing to purchase loans under those conditions.
19-2d Use of Securitization to Boost Liquidity
The ability to securitize assets such as automobile and mortgage loans can enhance a bank's liquidity position. The process of securitization commonly involves the sale of assets by the bank to a trustee, who issues securities that are collateralized by the assets. The bank may still service the loans, but the interest and principal payments it receives are passed on to the investors who purchased the securities. Banks are more liquid as a result of securitization because they effectively convert future cash flows into immediate cash. In most cases, the process includes a guarantor who, for a fee, guarantees future payments to the investors who purchased the securities. The loans that collateralize the securities normally either exceed the amount of the securities issued or are backed by an additional guarantee from the bank that sells the loans.
Collateralized Loan Obligations As one form of securitization, commercial banks can obtain funds by packaging their commercial loans with those of other financial institutions as collateralized loan obligations (CLOs) and then selling securities that represent ownership of these loans. The banks earn a fee for selling these loans. The pool of loans might be perceived to be less risky than a typical individual loan within the pool because the loans were provided to a diversified set of borrowers. The securities that are issued to investors who invest in the loan pool represent various classes.
For example, one class of notes issued to investors may be BB-rated notes, which offer an interest rate of LIBOR (London Interbank Offer Rate) plus 3.5 percent. If there are loan defaults by the corporate borrowers whose loans are in the pool, this group of investors will be the first to suffer losses. Another class may consist of BBB-rated notes that offer a slightly lower interest rate. Investors in these notes are slightly less exposed to defaults on the loans. The AAA-rated notes offer investors the most protection against loan defaults but provide the lowest interest rate, such as LIBOR plus 0.25 percent. Insurance companies and pension funds are common investors in CLOs.
Banks learned during the credit crisis that not all AAA-rated CLOs are risk free. Their CLOs experienced substantial defaults in 2008. The AAA rating was apparently based on the assumption of much better economic conditions than the crisis conditions that occurred in the second half of 2008.
19-3 MANAGING INTEREST RATE RISK
The performance of a bank is highly influenced by the interest payments earned on its assets relative to the interest paid on its liabilities (deposits). The difference between interest payments received and interest paid is measured by the net interest margin (also known as the spread):
Net interest margin =
|
Interest − Interest expenses |
|
Assets |
In some cases, net interest margin is defined to include only the earning assets so as to exclude any assets (such as required reserves) that do not generate a return to the bank. Because the rate sensitivity of a bank's liabilities normally does not perfectly match that of the assets, the net interest margin changes over time. The change depends on whether bank assets are more or less rate sensitive than bank liabilities, the degree of difference in rate sensitivity, and the direction of interest rate movements.
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, as illustrated in Exhibit 19.2 . Under the opposite scenario, when market interest rates are declining over time, rates offered on new bank deposits (as well as those earned on new bank loans) will be affected by the decline in interest rates. The deposit rates will typically be more sensitive if their turnover is quicker, as illustrated in Exhibit 19.3 .
To manage interest rate risk, a bank measures the risk and then uses its assessment of future interest rates to decide whether and how to hedge the risk. Methods of assessing the risk are described next, followed by a discussion of the hedging decision and methods of reducing interest rate risk.
19-3a Methods Used to Assess Interest Rate Risk
No method of measuring interest rate risk is perfect, so commercial banks use a variety of methods to assess their exposure to interest rate movements. The following are the most common methods of measuring interest rate risk:
· ▪ Gap analysis
· ▪ Duration analysis
· ▪ Regression analysis
Exhibit 19.2 Impact of Increasing Interest Rates on a Bank's Net Interest Margin (If the Bank's Liabilities Are More Rate Sensitive Than Its Assets)
Exhibit 19.3 Impact of Decreasing Interest Rates on a Bank's Net Interest Margin (If the Bank's Liabilities Are More Rate Sensitive Than Its Assets)
Gap Analysis Banks can attempt to determine their interest rate risk by monitoring their gap over time, where
Gap = Rate-sensitive assets − Rate-sensitive liabilities
An alternative formula is the gap ratio, which is measured as the volume of rate-sensitive assets divided by rate-sensitive liabilities. A gap of zero (or gap ratio of 1.00) indicates that rate-sensitive assets equal rate-sensitive liabilities, so the net interest margin should not be significantly influenced by interest rate fluctuations. A negative gap (or gap ratio of less than 1.00) indicates that rate-sensitive liabilities exceed rate-sensitive assets. Banks with a negative gap are typically concerned about a potential increase in interest rates, which could reduce their net interest margin.
EXAMPLE
Kansas City (K.C.) Bank had interest revenues of $80 million last year and interest expenses of $35 million. About $400 million of its $1 billion in assets are rate sensitive, and $700 million of its liabilities are rate sensitive. K.C. Bank's net interest margin is
K.C. Bank's gap is
and its gap ratio is
Based on the gap analysis of K.C. Bank, an increase in market interest rates would cause its net interest margin to decline from its recent level of 4.5 percent. Conversely, a decrease in interest rates would cause its net interest margin to increase above 4.5 percent.
Many banks classify interest-sensitive assets and liabilities into various categories based on the timing in which interest rates are reset. Then the bank can determine the gap in each category so that its exposure to interest rate risk can be more accurately assessed.
EXAMPLE
Deacon Bank compares the interest rate sensitivity of its assets versus its liabilities as shown in Exhibit 19.4 . It has a negative gap in the less-than-1-month maturity range, in the 3–6-month range, and in the 6–12-month range. Hence, the bank may hedge this gap if it believes that interest rates are rising.
Although the gap as described here is an easy method for measuring a bank's interest rate risk, it has limitations. Banks must determine which of their liabilities and assets are rate sensitive. For example, should a Treasury security with a year to maturity be classified as rate sensitive or rate insensitive? How short must a maturity be to qualify for the rate-sensitive classification?
Each bank may have its own classification system. Whatever system is used, there is a possibility that the measurement will be misinterpreted.
EXAMPLE
Spencer Bank obtains much of its funds by issuing COs with seven-day and one-month maturities as well as money market deposit accounts (MMDAs). Assume that it typically uses these funds to provide loans with a floating rate that is adjusted once per year. These sources and uses of funds will likely be classified as rate sensitive. Thus the gap will be close to zero, implying that the bank is not exposed to interest rate risk. However, there is a difference in rate sensitivity between the bank's sources and uses of funds: the rates paid by the bank on its sources of funds will change more frequently than the rates earned on its uses of funds. Thus, Spencer Bank's net interest margin will likely decline during periods of rising interest rates. This exposure would not be detected by the gap measurement.
Duration Measurement An alternative approach to assessing interest rate risk is to measure duration. Some assets or liabilities are more rate sensitive than others, even if the frequency of adjustment and the maturity are the same. A 10-year, zero-coupon bond is more sensitive to interest rate fluctuations than is a 10-year bond that generates coupon payments. Thus the market value of assets in a bank that has invested heavily in zero-coupon bonds will be susceptible to interest rate movements. The duration measurement can capture these different degrees of sensitivity. In recent years, banks and other financial institutions have used the concept of duration to measure the sensitivity of their assets to interest rate movements. There are various measurements for an asset's duration; one of the more common is
Exhibit 19.4 Interest-Sensitive Assets and Liabilities: Illustration of the Gap Measured for Various Maturity Ranges for Deacon Bank
Here Ct represents the interest or principal payments of the asset; t is the time at which the payments are provided; and k is the required rate of return on the asset, which reflects the asset's yield to maturity. The duration of each type of bank asset can be determined, and the duration of the asset portfolio is the weighted average (based on the relative proportion invested in each asset) of the durations of the individual assets.
The duration of each type of bank liability can also be estimated, and the duration of the liability portfolio is likewise estimated as the weighted average of the durations of the liabilities. The bank can then estimate its duration gap , which is commonly measured as the difference between the weighted duration of the bank's assets and the weighted duration of its liabilities, adjusted for the firm's asset size:
Here DURAS is the weighted average duration of the bank's assets, DURLIAB is the weighted average duration of the bank's liabilities, and AS and LIAB represent the market value of the bank's assets and liabilities, respectively. A duration gap of zero suggests that the bank's value should be insensitive to interest rate movements, meaning that the bank is not exposed to interest rate risk. For most banks, the average duration of assets exceeds the average duration of liabilities, so the duration gap is positive. This implies that the market value of the bank's assets is more sensitive to interest rate movements than the value of its liabilities. So if interest rates rise, banks with positive duration gaps will be adversely affected. Conversely, if interest rates decline, then banks with positive duration gaps will benefit. The larger the duration gap, the more sensitive the bank should be to interest rate movements.
Other things being equal, assets with shorter maturities have shorter durations; also, assets that generate more frequent coupon payments have shorter durations than those that generate less frequent payments. Banks and other financial institutions concerned with interest rate risk use duration to compare the rate sensitivity of their entire asset and liability portfolios. Because duration is especially critical for a savings institution's operations, Chapter 21 gives a numerical example showing the measurement of the duration of a savings institution's entire asset and liability portfolio.
Although duration is a valuable technique for comparing the rate sensitivity of various securities, its capabilities are limited when applied to assets that can be terminated on a moment's notice. For example, consider a bank that offers a fixed-rate, five-year loan that can be paid off early without penalty. If the loan is not paid off early, it is perceived as rate insensitive. Yet the loan could be terminated at any time over the five-year period. If it is paid off, the bank would reinvest the funds at the prevailing market rate. Thus the funds used to provide the loan can be sensitive to interest rate movements, but the degree of sensitivity depends on when the loan is paid off. In general, loan prepayments are more common when market rates decline because borrowers refinance by obtaining lower-rate loans to pay off existing loans. The point here is that the possibility of prepayment makes it impossible to perfectly match the rate sensitivity of assets and liabilities.
Regression Analysis Gap analysis and duration analysis are based on the bank's balance sheet composition. Alternatively, a bank can assess interest rate risk simply by determining how performance has historically been influenced by interest rate movements. This approach requires that proxies be identified for bank performance and for prevailing interest rates and that a model be chosen that can estimate the relationship between the proxies. Common proxies for performance include return on assets, return on equity, and the percentage change in stock price. To determine how performance is affected by interest rates, regression analysis can be applied to historical data. For example, using an interest rate proxy called i, the S&P 500 stock index as the market, and the bank's stock return (R) as the performance proxy, the following regression model could be used:
R = B0 + B1Rm + B2i + π
where Rm is the return on the market; B0, B1, and B2 are regression coefficients; and π is an error term. The regression coefficient B2 in this model can also be called the interest rate coefficient because it measures the sensitivity of the bank's performance to interest rate movements. A positive (negative) coefficient suggests that performance is favorably (adversely) affected by rising interest rates. If the interest rate coefficient is not significantly different from zero, this suggests that the bank's stock returns are insulated from interest rate movements.
Models similar to the one just described have been tested on the portfolio of all publicly traded banks to determine whether bank stock levels are affected by interest rate movements. The vast majority of this research has found that bank stock levels are inversely related to interest rate movements (i.e., the B2 coefficient is negative and significant). These results can be attributed to the common imbalance between a bank's rate-sensitive liabilities and its assets. Because banks tend to have a negative gap (their liabilities are more rate sensitive than their assets), rising interest rates reduce bank performance. These results are generalized for the banking industry and do not apply to every bank.
Because a bank's assets and liabilities are replaced over time, exposure to interest rate risk must be continually reassessed. As exposure changes, the reaction of bank performance to a particular interest rate pattern will change.
When a bank uses regression analysis to determine its sensitivity to interest rate movements, it may combine this analysis with the value-at-risk (VaR) method to determine how its market value would change in response to specific interest rate movements. The VaR method can be applied by combining a probability distribution of interest rate movements with the interest rate coefficient (measured from the regression analysis) to determine a maximum expected loss due to adverse interest rate movements.
EXAMPLE
After applying the regression model to monthly data, Dixon Bank determines that its interest rate regression coefficient is −2.4. This implies that, for a 1 percentage point increase in interest rates, the value of the bank would decline by 2.4 percent. The model also indicates (at the 99 percent confidence level) that the change in the interest rate should not exceed +2.0 percent. For a 2 percentage point increase, the value of Dixon Bank is expected to decline by 4.8 percent (computed as 2.0 percent multiplied by the regression coefficient of −2.4). Thus the maximum expected loss due to interest rate movements (based on a 99 percent confidence level) is a 4.8 percent loss in market value.
19-3b Whether to Hedge Interest Rate Risk
A bank can consider the measurement of its interest rate risk along with its forecast of interest rate movements to determine whether it should consider hedging that risk. The general conclusions resulting from a bank's analysis of its interest rate risk are presented in Exhibit 19.5 . This exhibit shows the three methods commonly used by banks to measure their interest rate risk. Since none of these measures is perfect for all situations, some banks measure interest rate risk using all three methods. Other banks prefer just one of the methods. Using any method along with an interest rate forecast can help a bank determine whether it should consider hedging its interest rate risk. However, since interest rate movements cannot always be accurately forecasted, banks should not be overly aggressive in attempting to capitalize on interest rate forecasts. They should assess the sensitivity of their future performance to each possible interest rate scenario that could occur to ensure that they can survive any possible scenario.
In general, the three methods of measuring interest rate risk should lead to a similar conclusion. If a bank has a negative gap, its average asset duration is probably larger than its liability duration (positive duration gap) and its past performance level is probably inversely related to interest rate movements. If a bank recently revised the composition of its assets or liabilities, it may wish to focus on the gap or the duration gap because regression analysis is based on a historical relationship that may no longer exist. Banks can use their analysis of gap along with their forecast of interest rates to make their hedging decision. If a bank decides to reduce its interest rate risk then it must consider the methods of hedging, which are described next.
Exhibit 19.5 Framework for Managing Interest Rate Risk
19-3c Methods Used to Reduce Interest Rate Risk
Interest rate risk can be reduced by
· • Maturity matching
· • Using floating-rate loans
· • Using interest rate futures contracts
· • Using interest rate swaps
· • Using interest rate caps
Maturity Matching One obvious method of reducing interest rate risk is to match each deposit's maturity with an asset of the same maturity. For example, if the bank receives funds for a one-year CD, it could provide a one-year loan or invest in a security with a one-year maturity. Although this strategy would avoid interest rate risk, it cannot be implemented effectively. Banks receive a large volume of short-term deposits and would not be able to match up maturities on deposits with the longer loan maturities. Borrowers rarely request funds for a period as short as one month or even six months. In addition, the deposit amounts are typically small relative to the loan amounts. A bank would have difficulty combining deposits with a particular maturity to accommodate a loan request with the same maturity.
Using Floating-Rate Loans An alternative solution is to use floating-rate loans, which allow banks to support long-term assets with short term deposits without overly exposing themselves to interest rate risk. However, floating-rate loans cannot completely eliminate the risk. If the cost of funds is changing more frequently than the rate on assets, the bank's net interest margin is still affected by interest rate fluctuations.
When banks reduce their exposure to interest rate risk by replacing long-term securities with more floating-rate commercial loans, they increase their exposure to credit risk because the commercial loans provided by banks typically have a higher frequency of default than the securities they hold. In addition, bank liquidity risk would increase because loans are less marketable than securities.
Using Interest Rate Futures Contracts Large banks frequently use interest rate futures and other types of derivative instruments to hedge interest rate risk. A common method of reducing interest rate risk is to use interest rate futures contracts, which lock in the price at which specified financial instruments can be purchased or sold on a specified future settlement date. Recall that the sale of a futures contract on Treasury bonds prior to an increase in interest rates will result in a gain, because an identical futures contract can be purchased later at a lower price once interest rates rise. Thus a gain on the Treasury bond futures contracts can offset the adverse effects of higher interest rates on a bank's performance. The size of the bank's position in Treasury bond futures should depend on the size of its asset portfolio, the degree of its exposure to interest rate movements, and its forecasts of future interest rate movements.
Exhibit 19.6 illustrates how the use of financial futures contracts can reduce the uncertainty about a bank's net interest margin. The sale of interest rate futures, for example, reduces the potential adverse effect of rising interest rates on the bank's interest expenses, yet it also reduces the potential favorable effect of declining interest rates on the bank's interest expenses. Assuming that the bank initially had more rate-sensitive liabilities, its use of futures would reduce the impact of interest rates on its net interest margin.
Using Interest Rate Swaps Commercial banks can hedge interest rate risk by engaging in an interest rate swap, which is an arrangement to exchange periodic cash flows based on specified interest rates. A fixed-for-floating swap allows one party to periodically exchange fixed cash flows for cash flows that are based on prevailing market interest rates.
Exhibit 19.6 Effect of Financial Futures on the Net Interest Margin of Banks That Have More Rate-Sensitive Liabilities Than Assets
A bank whose liabilities are more rate sensitive than its assets can swap payments with a fixed interest rate in exchange for payments with a variable interest rate over a specified period of time. If interest rates rise, the bank benefits because the payments to be received from the swap will increase while its outflow payments are fixed. This can offset the adverse impact of rising interest rates on the bank's net interest margin. An interest rate swap requires another party that is willing to provide variable-rate payments in exchange for fixed-rate payments. Financial institutions that have more rate-sensitive assets than liabilities may be willing to assume such a position because they could reduce their exposure to interest rate movements in this manner. A financial intermediary is typically needed to match up the two parties that desire an interest rate swap. Some securities firms and large commercial banks serve in this role.
EXAMPLE
Assume that Denver Bank (DB) has large holdings of 11 percent, fixed-rate loans. Because most of its sources of funds are sensitive to interest rates, DB desires to swap fixed-rate payments in exchange for variable-rate payments. It informs Colorado Bank of its situation because it knows that this bank commonly engages in swap transactions. Colorado Bank searches for a client and finds that Brit Eurobank desires to swap variable-rate dollar payments in exchange for fixed dollar payments. Colorado Bank then develops the swap arrangement illustrated in Exhibit 19.7 . Denver Bank will swap fixed-rate payments in exchange for variable-rate payments based on LIBOR (the rate charged on loans between Eurobanks). Because the variable-rate payments will fluctuate with market conditions, DB's payments received will vary over time. The length of the swap period and the notional amount (the amount to which the interest rates are applied in order to determine the payments) can be structured to meet the participants' needs. Colorado Bank, the financial intermediary conducting the swap, charges a fee amounting to 0.1 percent of the notional amount per year. Some financial intermediaries for swaps may serve as the counterparty and exchange the payments desired rather than matching up two parties.
Now assume that the fixed payments are based on a fixed rate of 9 percent. Also assume that LIBOR is initially 7 percent and that DB's cost of funds is 6 percent. Exhibit 19.8 shows how DB's spread is affected by various possible interest rates when unhedged versus when hedged with an interest rate swap. If LIBOR remains at 7 percent, DB's spread would be 5 percent if unhedged and only 3 percent when using a swap. However, if LIBOR increases beyond 9 percent, the spread when using the swap exceeds the unhedged spread because the higher cost of funds causes a lower unhedged spread. The swap arrangement would provide DB with increased payments that offset the higher cost of funds. The advantage of a swap is that it can lock in the spread to be earned on existing assets or at least reduce the possible variability of the spread.
Exhibit 19.7 Illustration of an Interest Rate Swap
When interest rates decrease, a bank's outflow payments would exceed inflow payments on a swap. However, the spread between the interest rates received on existing fixed-rate loans and those paid on deposits should increase, offsetting the net outflow from the swap. During periods of declining interest rates, fixed-rate loans are often prepaid, which could result in a net outflow from the swap without any offsetting effect.
Using Interest Rate Caps An alternative method of hedging interest rate risk is an interest rate cap, an agreement (for a fee) to receive payments when the interest rate of a particular security or index rises above a specified level during a specified time period. Various financial intermediaries (such as commercial banks and brokerage firms) offer interest rate caps. During periods of rising interest rates, the cap provides compensation that can offset the reduction in spread during such periods.
Exhibit 19.8 Comparison of Denver Bank's Spread: Unhedged versus Hedged
|
|
POSSIBLE FUTURE LIBOR RATES |
|||||
|
UNHEDGED STRATEGY |
7% |
8% |
9% |
10% |
11% |
12% |
|
Average rate on existing mortgages |
11% |
11% |
11% |
11% |
11% |
11% |
|
Average cost of deposits |
6 |
7 |
8 |
9 |
10 |
11 |
|
Spread |
5 |
4 |
3 |
2 |
1 |
0 |
|
HEDGING WITH AN INTEREST RATE SWAP |
||||||
|
Fixed interest rate earned on fixed-rate mortgages |
11 |
11 |
11 |
11 |
11 |
11 |
|
Fixed interest rate owed on swap arrangement |
9 |
9 |
9 |
9 |
9 |
9 |
|
Spread on fixed-rate payments |
2 |
2 |
2 |
2 |
2 |
2 |
|
Variable interest rate earned on swap arrangement |
7 |
8 |
9 |
10 |
11 |
12 |
|
Variable interest rate owed on deposits |
6 |
7 |
8 |
9 |
10 |
11 |
|
Spread on variable-rate payments |
1 |
1 |
1 |
1 |
1 |
1 |
|
Combined total spread when using the swap |
3 |
3 |
3 |
3 |
3 |
3 |
19-3d International Interest Rate Risk
When a bank has foreign currency balances, the strategy of matching the overall interest rate sensitivity of assets to that of liabilities will not automatically achieve a low degree of interest rate risk.
EXAMPLE
California Bank has deposits denominated mostly in euros, whereas its floating-rate loans are denominated mostly in dollars. It matches its average deposit maturity with its average loan maturity. However, the difference in currency denominations creates interest rate risk. The deposit and loan rates depend on the interest rate movements of the respective currencies. The performance of California Bank will be adversely affected if the interest rate on the euro increases and the U.S. interest rate decreases.
Even though a bank matches the mix of currencies in its assets and its liabilities, it can still be exposed to interest rate risk if the rate sensitivities differ between assets and liabilities for each currency.
EXAMPLE
Oklahoma Bank uses its dollar deposits to make dollar loans and its euro deposits to make euro loans. It has short-term dollar deposits and uses the funds to make long-term dollar loans. It also has medium-and long-term fixed-rate deposits in euros and uses those funds to make euro loans with adjustable rates. An increase in U.S. rates will reduce the spread on Oklahoma Bank's dollar loans versus deposits, because the dollar liabilities are more rate sensitive than the dollar assets. In addition, a decline in interest rates on the euro will decrease the spread on the euro loans versus deposits, because the euro assets are more rate sensitive than the euro liabilities. Thus exposure to interest rate risk can be minimized only if the rate sensitivities of assets and liabilities are matched for each currency.
WEB
Information about bank loan and deposit volume.
19-4 MANAGING CREDIT RISK
Most of a bank's funds are used either to make loans or to purchase debt securities. For either use of funds, the bank is acting as a creditor and is subject to credit (default) risk, or the possibility that credit provided by the bank will not be repaid. The types of loans provided and the securities purchased will determine the overall credit risk of the asset portfolio. A bank also can be exposed to credit risk if it serves as a guarantor on interest rate swaps and other derivative contracts in which it is the intermediary.
19-4a Measuring Credit Risk
An important part of managing credit risk is to assess the creditworthiness of prospective borrowers before extending credit. Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness. The evaluation should indicate the probability of the firm meeting its loan payments so that the bank can decide whether to grant the loan.
Determining the Collateral When a bank assesses a request for credit, it must decide whether to require collateral that can back the loan in case the borrower is unable to make the payments. For example, if a firm applies for a loan to purchase machinery, the loan agreement may specify that the machinery will serve as collateral. When a bank serves as an intermediary and a guarantor on derivative contracts, it commonly attempts to require collateral such as securities owned by the client.
Determining the Loan Rate If the bank decides to grant the loan, it can use its evaluation of the firm to determine the appropriate interest rate. Loan applicants deserving of a loan may be rated on a scale of 1 to 5 (with 1 as the highest quality) in terms of their degree of credit risk. The rating dictates the premium to be added to the base rate. For example, a rating of 5 may dictate a 2 percentage point premium above the prime rate (the rate a bank offers to its most creditworthy customers), while a rating of 3 may dictate a 1 percentage point premium. Given the current prime rate along with the rating of the potential borrower, the loan rate can be determined.
Some loans to high-quality (low-risk) customers are commonly offered at rates below the prime rate. This does not necessarily mean that the bank has reduced its spread. It may instead imply that the bank has redefined the prime rate to represent the appropriate loan rate for borrowers with a moderate risk rating. Thus a discount would be attached to the prime rate when determining the loan rate for borrowers with a superior rating.
Measuring Credit Risk of a Bank Portfolio The exposure of a bank's loan portfolio to credit risk is dependent on the types of loans that it provides. When it uses a larger proportion of loans for financing credit cards, it increases its exposure to credit risk. A bank's exposure also changes over time in response to economic conditions. As economic conditions weaken, the expected cash flows to be earned by businesses are reduced because their sales will likely decline. Consequently, they are more likely to default on loans. In addition, individuals are more likely to lose their jobs when the economy weakens, which could increase their likelihood of defaulting on loans.
19-4b Trade-off between Credit Risk and Return
If a bank wants to minimize credit risk, it can use most of its funds to purchase Treasury securities, which are virtually free of credit risk. However, these securities may not generate a much higher yield than the average overall cost of obtaining funds. In fact, some bank sources of funds can be more costly to banks than the yield earned on Treasury securities.
At the other extreme, a bank concerned with maximizing its return could use most of its funds to provide credit card and consumer loans. While this strategy may allow a bank to achieve a high return, these types of loans experience more defaults than other types of loans. Thus the bank may experience high loan losses, which could offset the high interest payments it received from those loans that were repaid. A bank that pursues the high potential returns associated with credit card loans or other loans that generate relatively high interest payments must accept a high degree of credit risk. Because riskier assets offer higher potential returns, a bank's strategy to increase its return on assets will typically entail an increase in the overall credit risk of its asset portfolio. Thus a bank's decision to create a very safe versus a moderate or high-risk asset portfolio is a function of its risk–return preferences.
Expected Return and Risk of Subprime Mortgage Loans Many commercial banks aggressively funded subprime mortgage loans in the 2004–2006 period by originating the mortgages or purchasing mortgage-backed securities that represented subprime mortgages. The banks pursuing this strategy expected that they would earn a relatively high interest rate compared to prime mortgages and that the subprime mortgages would have low default risk because the home serves as collateral. They provided many mortgages without requiring much collateral, as they presumed that market values of homes would continue to increase over time. Even after home prices increased substantially, many banks continued to aggressively offer subprime mortgages, as they were blinded by the expected return to be earned on this strategy without concern about risk. Perhaps many banks justified their strategy by trying to keep up with all other banks that were using an aggressive strategy for achieving high returns. Furthermore, since bank managerial compensation is commonly tied to the bank's earnings, they could benefit directly from pursuing aggressive strategies.
Bank managers did not anticipate the credit crisis in the 2008–2009 period, in which the value of many homes declined far below the amount owed on the mortgages. As the economy weakened, many homeowners were not able to continue their payments. The banks were forced to initiate mortgage foreclosures and sell some homes at a large discount in the weak housing market. Alternatively, some banks worked out arrangements with homeowners who were behind in their mortgage payments, but the banks had to provide more favorable terms so that the homeowners could afford the mortgage. Banks incurred major expenses from these arrangements.
19-4c Reducing Credit Risk
Although all consumer and commercial loans exhibit some credit risk, banks can use several methods to reduce this risk.
Industry Diversification of Loans Banks should diversity their loans to ensure that their customers are not dependent on a common source of income. For example, a bank in a small farming town that provides consumer loans to farmers and commercial loans to farm equipment manufacturers is highly susceptible to credit risk. If the farmers experience a bad growing season because of poor weather conditions, they may be unable to repay their consumer loans. Furthermore, the farm equipment manufacturers would simultaneously experience a drop in sales and may be unable to repay their commercial loans.
When a bank's loans are too heavily concentrated in a specific industry, it should attempt to expand its loans into other industries. In this way, if one particular industry experiences weakness (which will lead to loan defaults by firms in that industry), loans provided to other industries will be insulated from that industry's conditions. However, a bank's loan portfolio may still be subject to high credit risk even though its loans are diversified across industries.
International Diversification of Loans Many banks reduce their exposure to U.S. economic conditions by diversifying their loan portfolio internationally. They use a country risk assessment system to assess country characteristics that may influence the ability of a government or corporation to repay its debt. In particular, the country risk assessment focuses on a country's financial and political conditions. Banks are more likely to invest in countries to which they have assigned a high rating.
Diversifying loans across countries can often reduce the loan portfolio's exposure to any single economy or event. But if diversification across geographic regions means that the bank must accept loan applicants with very high risk, the bank is defeating its purpose. Furthermore, international diversification does not necessarily avoid adverse economic conditions. The credit crisis adversely affected most countries and therefore affected the ability of borrowers around the world to repay their loans.
Selling Loans Banks can eliminate loans that are causing excessive risk to their loan portfolios by selling them in the secondary market. Most loan sales enable the bank originating the loan to continue servicing it by collecting payments and monitoring the borrower's collateral. However, the bank that originated the loan is no longer funding it, so the loan is removed from the bank's assets. Bank loans are commonly purchased by other banks and financial institutions, such as pension funds, insurance companies, and mutual funds.
Revising the Loan Portfolio in Response to Economic Conditions Banks continuously assess both the overall composition of their loan portfolios and the economic environment. As economic conditions change, so does the risk of a bank's loan portfolio. A bank is typically more willing to extend loans during strong economic conditions because businesses are more likely to meet their loan payments under those conditions. During weak economic conditions, the bank is more cautious and increases its standards, which results in a smaller amount of new loans extended to businesses. Under these conditions, the bank typically increases the credit it extends to the Treasury by purchasing more Treasury securities. Nevertheless, its loan portfolio may still be heavily exposed to economic conditions because some of the businesses that have already borrowed may be unable to repay their loans.
WEB
Analytical assessment of the banking industry, including the recent performance of banks.
19-5 MANAGING MARKET RISK
From a bank management perspective, market 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, they have become much more susceptible to market risk. For example, some banks now provide loans to various types of investment funds, which use the borrowed funds to invest in stocks or derivative securities. Thus these loans may not be repaid if the prices of the stocks or derivative securities held by the investment funds decline substantially.
The increase in banks' exposure to market risk is also attributed to their increased participation in the trading of derivative contracts. Many banks now serve as intermediaries between firms that take positions in derivative securities and will be exchanging payments in the future. For some of these transactions, a bank serves as a guarantor to one of the parties if the counterparty in the transaction does not fulfill its payment obligation. If derivative security prices change abruptly and cause several parties involved in these transactions to default, a bank that served as a guarantor could suffer major losses. Furthermore, banks that purchase debt securities issued in developing countries are subject to abrupt losses resulting from sudden swings in the economic or currency conditions in those countries.
19-5a Measuring Market Risk
Banks commonly measure their exposure to market risk by applying the value-at-risk (VaR) method, which involves determining the largest possible loss that would occur as a result of changes in market prices based on a specified percent confidence level. To estimate this loss, the bank first determines an adverse scenario (e.g., a 20 percent decline in derivative security prices) that has a 1 percent chance of occurring. Then it estimates the impact of that scenario on its investment or loan positions given the sensitivity of investments' values to the scenario. All of the losses that would occur from the bank's existing positions are summed to determine the estimated total loss to the bank under this scenario. This estimate reflects the largest possible loss at the 99 percent confidence level, since there is only a 1-in-100 chance that such an unfavorable scenario would occur. By determining its exposure to market risk, the bank can ensure that it has sufficient capital to cushion against the adverse effects of such an event.
Bank Revisions of Market Risk Measurements Banks continually revise their estimate of market risk in response to changes in their investment and credit positions and to changes in market conditions. When market prices become more volatile, banks recognize that market prices could change to a greater degree and typically increase their estimate of their potential losses due to market conditions.
Relationship between a Bank's Market Risk and Interest Rate Risk A bank's market risk is partially dependent on its exposure to interest rate risk. Banks give special attention to interest rate risk, because it is commonly the most important component of market risk. Moreover, many banks assess interest rate risk by itself when evaluating their positions over a longer time horizon. For example, a bank might assess interest rate risk over the next year using the methods described earlier in the chapter. In this case, the bank might use the assessment to alter the maturities on the deposits it attempts to obtain or on its uses of funds. In contrast, banks' assessment of market risk tends to be focused on a shorter-term horizon, such as the next month. Nevertheless, banks may still use their assessment of market risk to alter their operations, as explained next.
19-5b Methods Used to Reduce Market Risk
WEB
Statistical overview of how banks have performed in recent years.
If a bank determines that its exposure to market risk is excessive, it can reduce its involvement in the activities that cause the high exposure. For example, the bank could reduce the amount of transactions in which it serves as guarantor for its clients or reduce its investment in foreign debt securities that are subject to adverse events in a specific region. Alternatively, it could attempt to take some trading positions to offset some of its exposure to market risk. It could also sell some of its securities that are heavily exposed to market risk.
19-6 INTEGRATED BANK MANAGEMENT
Bank management of assets, liabilities, and capital is integrated. A bank's asset growth can be achieved only if it obtains the necessary funds. Furthermore, growth may require an investment in fixed assets (such as additional offices) that will require an accumulation of bank capital. Integration of asset, liability, and capital management ensures that all policies will be consistent with a cohesive set of economic forecasts. An integrated management approach is necessary to manage liquidity risk, interest rate risk, and credit risk.
19-6a Application
Assume that you are hired as a consultant by Atlanta Bank to evaluate its favorable and unfavorable aspects. Atlanta Bank's balance sheet is shown in Exhibit 19.9 . A bank's balance sheet can best be evaluated by converting the actual dollar amounts of balance sheet components to a percentage of assets. This conversion enables the bank to be compared with its competitors. Exhibit 19.10 shows each balance sheet component as a percentage of total assets for Atlanta Bank (derived from Exhibit 19.9 ). To the right of each bank percentage is the assumed industry average percentage for a sample of banks with a similar amount of assets. For example, the bank's required reserves are 4 percent of assets (the same as the industry average), its floating-rate commercial loans are 30 percent of assets (versus an industry average of 20 percent), and so on. The same type of comparison is provided for liabilities and capital on the right side of the exhibit. A comparative analysis relative to the industry can indicate the management style of Atlanta Bank.
Exhibit 19.9 Balance Sheet of Atlanta Bank (in Millions of Dollars)
|
ASSETS |
|
LIABILITIES AND CAPITAL |
|||
|
Required reserves |
|
$400 |
Demand deposits |
|
$500 |
|
Commercial loans |
|
|
NOW accounts |
|
1,200 |
|
Floating-rate |
3,000 |
|
MMDAs |
2,000 |
|
|
Fixed-rate |
1,100 |
|
CDs |
|
|
|
Total |
|
4,100 |
Short-term |
1,500 |
|
|
Consumer loans |
|
2,500 |
From 1 to 5 years. |
3,800 |
|
|
Mortgages |
|
|
Total |
|
5,300 |
|
Floating-rate |
500 |
|
Long-term bonds |
|
200 |
|
Fixed-rate |
None |
|
CAPITAL |
|
800 |
|
Total |
|
500 |
|
|
|
|
Treasury securities |
|
|
|
|
|
|
Short-term |
1,000 |
|
|
|
|
|
Long-term |
None |
|
|
|
|
|
Total |
|
1,000 |
|
|
|
|
Corporate securities |
|
|
|
|
|
|
High-rated |
None |
|
|
|
|
|
Medium-rated |
1,000 |
|
|
|
|
|
Total |
1,000 |
|
|
|
|
|
Municipal securities |
|
|
|
|
|
|
High-rated |
None |
|
|
|
|
|
Medium-rated |
None |
|
|
|
|
|
Total |
|
None |
|
|
|
|
Fixed assets |
|
500 |
|
|
|
|
TOTAL ASSETS |
|
$10,000 |
TOTAL LIABILITIES AND CAPITAL |
|
$10,000 |
It is possible to evaluate the potential level of interest revenues, interest expenses, noninterest revenues, and noninterest expenses for Atlanta Bank relative to the industry. Furthermore, it is possible to assess the bank's exposure to credit risk and interest rate risk as compared to the industry.
A summary of Atlanta Bank based on the information in Exhibit 19.10 is provided in Exhibit 19.11 . Although its interest expenses are expected to be above the industry average, so are its interest revenues. Thus it is difficult to determine whether Atlanta Bank's net interest margin will be above or below the industry average. Because it is more heavily concentrated in risky loans and securities, its credit risk is higher than that of the average bank; however, its interest rate risk is less because of its relatively high concentration of medium-term CDs and floating-rate loans. A gap measurement of Atlanta Bank can be conducted by first identifying the rate-sensitive liabilities and assets, as follows:
Exhibit 19.10 Comparative Balance Sheet of Atlanta Bank
|
ASSETS |
LIABILITIES AND CAPITAL |
||||
|
|
PERCENTAGE OF ASSETS FOR ATLANTA BANK |
AVERAGE PERCENTAGE FOR INDUSTRY |
|
PERCENTAGE OF TOTAL FOR ATLANTA BANK |
AVERAGE PERCENTAGE FOR INDUSTRY |
|
Required reserves |
4% |
4% |
Demand deposits |
5% |
17% |
|
Commercial loans |
|
|
NOW accounts |
12 |
8 |
|
Floating-rate |
30 |
20 |
MMDAs |
20 |
20 |
|
Fixed-rate |
11 |
11 |
CDs |
|
|
|
Total |
41 |
31 |
Short-term |
15 |
35 |
|
Consumer loans |
25 |
20 |
From 1 to 5 years |
38 |
10 |
|
Mortgages |
|
|
Long-term bonds |
2 |
2 |
|
Floating-rate |
5 |
7 |
CAPITAL |
8 |
8 |
|
Fixed-rate |
0 |
3 |
|
|
|
|
Total |
5 |
10 |
|
|
|
|
Treasury securities |
|
|
|
|
|
|
Short-term |
10 |
7 |
|
|
|
|
Long-term |
0 |
8 |
|
|
|
|
Total |
10 |
15 |
|
|
|
|
Corporate securities |
|
|
|
|
|
|
High-rated |
0 |
5 |
|
|
|
|
Medium-rated |
10 |
5 |
|
|
|
|
Total |
10 |
10 |
|
|
|
|
Municipal securities |
|
|
|
|
|
|
High-rated |
0 |
3 |
|
|
|
|
Medium-rated |
0 |
2 |
|
|
|
|
Total |
0 |
5 |
|
|
|
|
Fixed assets |
5 |
5 |
|
|
|
|
TOTAL ASSETS |
100% |
100% |
TOTAL LIABILITIES AND CAPITAL |
100% |
100% |
Exhibit 19.11 Evaluation of Atlanta Bank Based on Its Balance Sheet
|
|
MAIN INFLUENTIAL COMPONENTS |
EVALUATION OF ATLANTA BANK RELATIVE TO INDUSTRY |
|
|
Interest expenses |
All liabilities except demand deposits |
Higher than industry average because it concentrates more on high-rate deposits than the norm |
|
|
Noninterest expenses |
Loan volume and checkable deposit volume |
Possibly higher than the norm; its checkable deposit volume is less than the norm, but its loan volume is greater than the norm |
|
|
Interest revenues |
Volume and composition of loans and securities |
Potentially higher than industry average because its assets are generally riskier than the norm |
|
|
Exposure to credit risk |
Volume and composition of loans and securities |
Higher concentration of loans than industry average; it has a greater percentage of risky assets than the norm |
|
|
Exposure to interest rate risk |
Maturities on liabilities and assets; use of floating-rate loans |
Lower than the industry average; it has more medium-term liabilities, fewer assets with very long maturities, and more floating-rate loans |
|
|
RATE-SENSITIVE ASSETS |
AMOUNT (IN MILLIONS) |
RATE-SENSITIVE LIABILITIES |
AMOUNT (IN MILLIONS) |
|
Floating-rate loans |
$3,000 |
NOW accounts |
$1,200 |
|
Floating-rate mortgages |
500 |
MMDAs |
2,000 |
|
Short-term Treasury securities |
1,000 |
Short-term CDs |
1,500 |
|
Total |
$4,500 |
Total |
$4,700 |
The gap measurements suggest a similar rate sensitivity on both sides of the balance sheet.
The future performance of Atlanta Bank relative to the industry depends on future economic conditions. If interest rates rise then it will be more insulated than other banks; if interest rates fall, other banks will likely benefit to a greater degree. Under conditions of a strong economy, Atlanta Bank would likely benefit more than other banks because of its aggressive lending approach. Conversely, an economic slowdown could cause more loan defaults, and Atlanta Bank would be more susceptible to possible defaults than other banks. This could be confirmed only if more details were provided (such as a more comprehensive breakdown of the balance sheet).
Management of Bank Capital An evaluation of Atlanta Bank should also include an assessment of its capital. As with all banks, the future performance of Atlanta Bank is influenced by the amount of capital that it holds. It needs to maintain at least the minimum capital ratio required by regulators. However, if Atlanta Bank maintains too much capital, each shareholder will receive a smaller proportion of any distributed earnings. A common measure of the return to the shareholders is the return on equity (ROE), measured as
ROE =
|
Net profit after taxes |
|
Equity |
The term equity represents the bank's capital. The return on equity can be broken down as follows:
ROE = Return on assets (ROA) × Leverage measure
|
Net profit after taxes |
|
Equity |
=
|
Net profit after taxes |
|
Assets |
×
|
Assets |
|
Equity |
The ratio (assets/equity) is sometimes called the leverage measure because leverage reflects the volume of assets a firm supports with equity. The greater the leverage measure, the greater the amount of assets per dollar's worth of equity. The preceding breakdown of ROE is useful because it demonstrates how Atlanta Bank's capital can affect its ROE. For a given level of return on assets (ROA), a higher capital level reduces the bank's leverage measure and therefore reduces its ROE.
WEB
Links to risk-related information in international banking.
If Atlanta Bank is holding an excessive amount of capital, it may not need to rely on retained earnings to build its capital and so can distribute a high percentage of its earnings to shareholders (as dividends). Thus its capital management is related to its dividend policy. If Atlanta Bank is expanding, it may need more capital to support construction of new buildings, office equipment, and other expenses. In this case, it would need to retain a larger proportion of its earnings to support its expansion plans.
19-7 MANAGING RISK OF INTERNATIONAL OPERATIONS
Banks that are engaged in international banking face additional types of risk, including exchange rate risk and settlement risk.
19-7a Exchange Rate Risk
When a bank providing a loan requires that the borrower repay in the currency denominating the loan, it may be able to avoid exchange rate risk. However, some international loans contain a clause that allows repayment in a foreign currency, thus allowing the borrower to avoid exchange rate risk.
In many cases, banks convert available funds (from recent deposits) to whatever currency corporations want to borrow. Thus, they create an asset denominated in that currency while the liability (deposits) is denominated in a different currency. If the liability currency appreciates against the asset currency, the bank's profit margin is reduced.
All large banks are exposed to exchange rate risk to some degree. They can attempt to hedge this risk in various ways.
EXAMPLE
Cameron Bank, a U.S. bank, converts dollar deposits into a British pound (£) loan for a British corporation, which will pay £50,000 in interest per year. Cameron Bank may attempt to engage in forward contracts to sell £50,000 forward for each date when it will receive those interest payments. That is, it will search for corporations that wish to purchase £50,000 on the dates of concern.
In practice, a large bank will not hedge every individual transaction and instead will net out the exposure and be concerned only with net exposure. Large banks enter into several international transactions on any given day. Some reflect future cash inflows in a particular currency while others reflect cash outflows in that currency. The bank's exposure to exchange rate risk is determined by the net cash flow in each currency.
19-7b Settlement Risk
International banks that engage in large currency transactions are exposed not only to exchange rate risk as a result of their different currency positions but also to settlement risk, or the risk of a loss due to settling their transactions. For example, a bank may send its currency to another bank as part of a transaction agreement, yet it may not receive any currency from the other bank if that bank defaults before sending its payment.
The failure of a single large bank could create more losses if other banks were relying on receivables from the failed bank to make future payables of their own. Consequently, there is concern about systemic risk, or the risk that many participants will be unable to meet their obligations because they did not receive payments on obligations due to them.
SUMMARY
· ▪ The underlying goal of bank management is to maximize the wealth of the bank's shareholders, which implies maximizing the price of the bank's stock (if the bank is publicly traded). A bank's board of directors needs to monitor bank managers to ensure that managerial decisions are intended to serve shareholders.
· ▪ Banks manage liquidity by maintaining some liquid assets such as short-term securities and ensuring easy access to funds (through the federal funds market).
· ▪ Banks measure their sensitivity to interest rate movements so that they can assess their exposure to interest rate risk. Common methods of measuring interest rate risk include gap analysis, duration analysis, and measuring the sensitivity of earnings (or stock returns) to interest rate movements.
· ▪ Banks can reduce their interest rate risk by matching the maturities of their assets and liabilities or by using floating-rate loans to create more rate sensitivity in their assets. Alternatively, they could sell financial futures contracts or engage in a swap of fixed-rate payments for floating-rate payments.
· ▪ Banks manage credit risk by carefully assessing the borrowers who apply for loans and by limiting the amount of funds they allocate toward risky loans (such as credit card loans). They also diversify their loans across borrowers of different regions and industries so that the loan portfolio is not overly susceptible to financial problems in any single region or industry.
· ▪ An evaluation of a bank includes assessment of its exposure to interest rate movements and to credit risk. This assessment can be used along with a forecast of interest rates and economic conditions to forecast the bank's future performance.
POINT COUNTER-POINT
Can Bank Failures Be Avoided?
Point No. Banks are in the business of providing credit. When economic conditions deteriorate, there will be loan defaults and some banks will not be able to survive.
Counter-Point Yes. If banks focus on providing loans to creditworthy borrowers, most loans will not default even during recessionary periods.
Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion.
QUESTIONS AND APPLICATIONS
· 1. Integrating Asset and Liability Management What is accomplished when a bank integrates its liability management with its asset management?
· 2. Liquidity Given the liquidity advantage of holding Treasury bills, why do banks hold only a relatively small portion of their assets as T-bills?
· 3. Illiquidity How do banks resolve illiquidity problems?
· 4. Managing Interest Rate Risk If a bank expects interest rates to decrease over time, how might it alter the rate sensitivity of its assets and liabilities?
· 5. Rate Sensitivity List some rate-sensitive assets and some rate-insensitive assets of banks.
· 6. Managing Interest Rate Risk If a bank is very uncertain about future interest rates, how might it insulate its future performance from future interest rate movements?
· 7. Net Interest Margin What is the formula for the net interest margin? Explain why it is closely monitored by banks.
· 8. Managing Interest Rate Risk Assume that a bank expects to attract most of its funds through short-term CDs and would prefer to use most of its funds to provide long-term loans. How could it follow this strategy and still reduce interest rate risk?
· 9. Bank Exposure to Interest Rate Movements According to this chapter, have banks been able to insulate themselves against interest rate movements? Explain.
· 10. Gap Management What is a bank's gap, and what does it attempt to determine? Interpret a negative gap. What are some limitations of measuring a bank's gap?
· 11. Duration How do banks use duration analysis?
· 12. Measuring Interest Rate Risk Why do loans that can be prepaid on a moment's notice complicate the bank's assessment of interest rate risk?
· 13. Bank Management Dilemma Can a bank simultaneously maximize return and minimize default risk? If not, what can it do instead?
· 14. Bank Exposure to Economic Conditions As economic conditions change, how do banks adjust their asset portfolios?
· 15. Bank Loan Diversification In what two ways should a bank diversify its loans? Why? Is international diversification of loans a viable strategy for dealing with credit risk? Defend your answer.
· 16. Commercial Borrowing Do all commercial borrowers receive the same interest rate on loans?
· 17. Bank Dividend Policy Why might a bank retain some excess earnings rather than distribute them as dividends?
· 18. Managing Interest Rate Risk If a bank has more rate-sensitive liabilities than rate-sensitive assets, what will happen to its net interest margin during a period of rising interest rates? During a period of declining interest rates?
· 19. Floating-Rate Loans Does the use of floating-rate loans eliminate interest rate risk? Explain.
· 20. Managing Exchange Rate Risk Explain how banks become exposed to exchange rate risk.
Advanced Questions
· 21. Bank Exposure to Interest Rate Risk Oregon Bank has branches overseas that concentrate on short-term deposits in dollars and floating-rate loans in British pounds. Because it maintains rate-sensitive assets and liabilities of equal amounts, it believes it has essentially eliminated its interest rate risk. Do you agree? Explain.
· 22. Managing Interest Rate Risk Dakota Bank has a branch overseas with the following balance sheet characteristics: 50 percent of the liabilities are rate sensitive and denominated in Swiss francs; the remaining 50 percent of liabilities are rate insensitive and are denominated in dollars. With regard to assets, 50 percent are rate sensitive and are denominated in dollars; the remaining 50 percent of assets are rate insensitive and are denominated in Swiss francs.
· a. Is the performance of this branch susceptible to interest rate movements? Explain.
· b. Assume that Dakota Bank plans to replace its short-term deposits denominated in U.S. dollars with short-term deposits denominated in Swiss francs because Swiss interest rates are currently lower than U.S. interest rates. The asset composition would not change. This strategy is intended to widen the spread between the rate earned on assets and the rate paid on liabilities. Offer your insight on how this strategy could backfire.
· c. One consultant has suggested to Dakota Bank that it could avoid exchange rate risk by making loans in whatever currencies it receives as deposits. In this way, it will not have to exchange one currency for another. Offer your insight on whether there are any disadvantages to this strategy.
Interpreting Financial News
· a. “The bank's biggest mistake was that it did not recognize that its forecasts of a strong local real estate market and declining interest rates could be wrong.”
· b. “Banks still need some degree of interest rate risk to be profitable.”
· c. “The bank used interest rate swaps so that its spread is no longer exposed to interest rate movements. However, its loan volume and therefore its profits are still exposed to interest rate movements.”
Managing in Financial Markets
Hedging with Interest Rate Swaps As a manager of Stetson Bank, you are responsible for hedging Stetson's interest rate risk. Stetson has forecasted its cost of funds as follows
|
YEAR |
COST OF FUNDS |
|
1 |
6% |
|
2 |
5% |
|
3 |
7% |
|
4 |
9% |
|
5 |
7% |
It expects to earn an average rate of 11 percent on some assets that charge a fixed interest rate over the next five years. It considers engaging in an interest rate swap in which it would swap fixed payments of 10 percent in exchange for variable-rate payments of LIBOR plus 1 percent. Assume LIBOR is expected to be consistently 1 percent above Stetson's cost of funds.
· a. Determine the spread that would be earned each year if Stetson uses an interest rate swap to hedge all of its interest rate risk. Would you recommend that Stetson use an interest rate swap?
· b. Although Stetson has forecasted its cost of funds, it recognizes that its forecasts may be inaccurate. Offer a method that Stetson can use to assess the potential results from using an interest rate swap while accounting for the uncertainty surrounding future interest rates.
· c. The reason for Stetson's interest rate risk is that it uses some of its funds to make fixed- rate loans, as some borrowers prefer fixed rates. An alternative method of hedging interest rate risk is to use adjustable-rate loans. Would you recommend that Stetson use only adjustable-rate loans to hedge its interest rate risk? Explain.
PROBLEMS
· 1. Net Interest Margin Suppose a bank earns $201 million in interest revenue but pays $156 million in interest expense. It also has $800 million in earning assets. What is its net interest margin?
· 2. Calculating Return on Assets If a bank earns $169 million net profit after tax and has $17 billion invested in assets, what is its return on assets?
· 3. Calculating Return on Equity If a bank earns $75 million net profits after tax and has $7.5 billion invested in assets and $600 million equity investment, what is its return on equity?
· 4. Managing Risk Use the balance sheet for San Diego Bank in Exhibit A and the industry norms in Exhibit B to answer the following questions.
· a. Estimate the gap and the gap ratio and determine how San Diego Bank would be affected by an increase in interest rates over time.
· b. Assess San Diego's credit risk. Does it appear high or low relative to the industry? Would San Diego Bank perform better or worse than other banks during a recession?
Exhibit ABalance Sheet for San Diego Bank (in Millions of Dollars)
|
ASSETS |
|
LIABILITIES AND CAPITAL |
|
||
|
Required reserves |
|
$800 |
Demand deposits |
|
$800 |
|
Commercial loans |
|
|
NOW accounts |
2,500 |
|
|
Floating-rate |
None |
|
MMDAs |
6,000 |
|
|
Fixed-rate |
7,000 |
|
CDs |
|
|
|
Total |
|
7,000 |
Short-term |
9,000 |
|
|
Consumer loans |
|
5,000 |
From 1 to 5 yrs. |
None |
|
|
Mortgages |
|
|
Total |
|
9,000 |
|
Floating-rate |
None |
|
Federal funds |
|
500 |
|
Fixed-rate |
2,000 |
|
Long-term bonds |
|
400 |
|
Total |
|
2,000 |
CAPITAL |
|
800 |
|
Treasury securities |
|
|
|
|
|
|
Short-term |
None |
|
|
|
|
|
Long-term |
1,000 |
|
|
|
|
|
Total |
|
1,000 |
|
|
|
|
Long-term corporate securities |
|
|
|
|
|
|
High-rated |
None |
|
|
|
|
|
Moderate-rated |
2,000 |
|
|
|
|
|
Total |
|
2,000 |
|
|
|
|
Long-term municipal securities |
|
|
|
|
|
|
High-rated |
None |
|
|
|
|
|
Moderate-rated |
1,700 |
|
|
|
|
|
Total |
|
1,700 |
|
|
|
|
Fixed assets |
|
500 |
|
|
|
|
TOTAL ASSETS |
|
$20,000 |
TOTAL LIABILITIES and CAPITAL |
|
$20,000 |
Exhibit BIndustry Norms in Percentage Terms
|
ASSETS |
|
LIABILITIES AND CAPITAL |
|
|
Required reserves |
4% |
Demand deposits |
17% |
|
Commercial loans |
|
NOW accounts |
10 |
|
Floating-rate |
20 |
MMDAs |
20 |
|
Fixed-rate |
11 |
CDs |
|
|
Total |
31 |
Short-term |
35 |
|
Consumer loans |
20 |
From 1 to 5 yrs. |
10 |
|
Mortgages |
|
Total |
45 |
|
Floating-rate |
7 |
Long-term bonds |
2 |
|
Fixed-rate |
3 |
CAPITAL |
6 |
|
Total |
10 |
|
|
|
Treasury securities |
|
|
|
|
Short-term |
7 |
|
|
|
Long-term |
8 |
|
|
|
Total |
15 |
|
|
|
Long-term corporate securities |
|
|
|
|
High-rated |
5 |
|
|
|
Moderate-rated |
5 |
|
|
|
Total |
10 |
|
|
|
Long-term municipal securities |
|
|
|
|
High-rated |
3 |
|
|
|
Moderate-rated |
2 |
|
|
|
Total |
5 |
|
|
|
Fixed assets |
5 |
|
|
|
TOTAL ASSETS |
100% |
TOTAL LIABILITIES and CAPITAL |
100% |
· c. For any type of bank risk that appears to be higher than the industry, explain how the balance sheet could be restructured to reduce the risk.
· 5. Measuring Risk Montana Bank wants to determine the sensitivity of its stock returns to interest rate movements, based on the following information:
|
QUARTER |
RETURN ON MONTANA STOCK |
RETURN ON MARKET |
INTEREST RATE |
|
1 |
2% |
3% |
6.0% |
|
2 |
2 |
2 |
7.5 |
|
3 |
1 |
2 |
9.0 |
|
4 |
0 |
1 |
8.2 |
|
5 |
2 |
1 |
7.3 |
|
6 |
3 |
4 |
8.1 |
|
7 |
1 |
5 |
7.4 |
|
8 |
0 |
1 |
9.1 |
|
9 |
2 |
0 |
8.2 |
|
10 |
1 |
1 |
7.1 |
|
11 |
3 |
3 |
6.4 |
|
12 |
6 |
4 |
5.5 |
Use a regression model in which Montana's stock return is a function of the stock market return and the interest rate. Determine the relationship between the interest rate and Montana's stock return by assessing the regression coefficient applied to the interest rate. Is the sign of the coefficient positive or negative? What does it suggest about the bank's exposure to interest rate risk? Should Montana Bank be concerned about rising or declining interest rate movements in the future?
FLOW OF FUNDS EXERCISE
Managing Credit Risk
Recall that Carson Company relies heavily on commercial banks for loans. When the company was first established with equity funding from its owners, Carson Company could easily obtain debt financing because the financing was backed by some of the firm's assets. However, as Carson expanded, it continually relied on extra debt financing, which increased its ratio of debt to equity. Some banks were unwilling to provide more debt financing because of the risk that Carson would not be able to repay additional loans. A few banks were still willing to provide funding, but they required an extra premium to compensate for the risk.
· a. Explain the difference in the willingness of banks to provide loans to Carson Company. Why is there a difference between banks when they are assessing the same information about a firm that wants to borrow funds?
· b. Consider the flow of funds for a publicly traded bank that is a key lender to Carson Company. This bank received equity funding from shareholders, which it used to establish its business. It channels bank deposit funds, which are insured by the Federal Deposit Insurance Corporation (FDIC), to provide loans to Carson Company and other firms. The depositors have no idea how the bank uses their funds. Yet, the FDIC does not prevent the bank from making risky loans. So who is monitoring the bank? Do you think the bank is taking more risk than its shareholders desire? How does the FDIC discourage the bank from taking too much risk? Why might the bank ignore the FDIC's efforts to discourage excessive risk taking?
INTERNET/EXCEL EXERCISES
· 1. Assess the services offered by an Internet bank. Describe the types of online services offered by the bank. Do you think an Internet bank such as this offers higher or lower interest rates than a “regular” commercial bank? Why or why not?
· 2. Go to finance.yahoo.com/ , enter the symbol BK (Bank of New York Mellon Corporation), and click on “Get Quotes.” Click on “5y” just below the stock price trend to review the stock price movements over the last five years. Click on “Compare” and then on “S&P 500” in order to compare the trend of Bank of New York Mellon with the movements in the S&P stock index. Has Bank of New York Mellon Corporation performed better or worse than the index? Offer an explanation for its performance.
· 3. Go to finance.yahoo.com/ , enter the symbol WFC (Wells Fargo Bank), and click on “Get Quotes.” Retrieve stock price data at the beginning of the last 20 quarters. Then go to http://research.stlouisfed.org/fred2/ and retrieve interest rate data at the beginning of the last 20 quarters for the three-month Treasury bill. Record the data on an Excel spreadsheet. Derive the quarterly return of Wells Fargo Bank. Derive the quarterly change in the interest rate. Apply regression analysis in which the quarterly return of Wells Fargo Bank is the dependent variable and the quarterly change in the interest rate is the independent variable (see Appendix B for more information about using regression analysis). Is there a positive or negative relationship between the interest rate movement and the return of Wells Fargo Bank stock? Is the relationship significant? Offer an explanation for this relationship.
WSJ EXERCISE
Bank Management Strategies
Summarize an article in the Wall Street Journal that discussed a recent change in managerial strategy by a particular commercial bank. (You may wish to do an Internet search in the online version of the Wall Street Journal to identify an article on a commercial bank's change in strategy.) Describe the change in managerial strategy. How will the bank's balance sheet be affected by this change? How will the bank's potential return and risk be affected? What reason does the article give for the bank's decision to change its strategy?
ONLINE ARTICLES WITH REAL-WORLD EXAMPLES
Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.
If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.
For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):
· 1. [name of a specific bank] AND liquidity
· 2. [name of a specific bank] AND management
· 3. [name of a specific bank] AND interest rate risk
· 4. [name of a specific bank] AND credit risk
· 5. [name of a specific bank] AND strategy
· 6. bank AND management
· 7. bank AND strategy
· 8. bank AND loans
· 9. bank AND asset management
· 10. bank AND operations