(6) RISK MANAGEMENT IN BANKS

Core Reading
• ME, Ch 3 & 23 (17 for background) or M Ch 9

What do banks do?

Typical financial intermediary
• Provide loans to finance businesses, education, purchases
• Services such as checking and savings accounts:
o Collect money (deposits) from clients and lend that money to borrowers for interest
• Expertise in reducing transaction costs & asymmetric information
o Screening projects after issuing loans
o Chasing loan payments
• Maturity, liquidity and risk transformations

Bank Balance Sheet

Total Assets = Total Liabilities + Capital (Equity)

Liabilities
• Checkable deposits
o Bank accounts that allow the owner of the account to write checks to 3rd parties
o Payable on demand
§ If a depositor requests a withdrawal, the bank must pay the depositor
immediately
• Non-transaction deposits
o Primary source of bank funds
o Interest paid on these is higher than on checkable accounts as owners can’t make
transactions
o Savings account:
§
o Time deposits (certificates of deposit/CDs):
§ Have a maturity during which you cannot withdraw money or face early
withdrawal penalties
§ Earn higher interest
§ Small time deposit accounts (<$100k) are less liquid and cost more for the bank
to run
• Borrowings
o Borrow money from Federal Reserve and other banks & corporations
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§ Borrow money overnight from Federal Reserve to have enough deposits to meet
the minimum requirement
• Bank Capital
o Difference between assets and liabilities
o Raised by selling stock or from retained earnings
o Cushion in case bank assets drop, so the bank does not become insolvent
§ i.e. bank’s assets cannot cover liabilities

Assets
• Reserves
o Funds held as ‘vault cash’ and deposits at the Fed
o Required to meet the reserve requirements
§ For every dollar deposit, a fraction of that needs to be put aside to reserves
o Excess reserves are most liquid and kept to meet withdrawal obligations
• Cash
o Check written from another bank that is yet to be processed
• Deposits at other banks
• Securities
o Hold state and local government securities as governments more likely to engage in
business with banks that hold their securities
• Loans
o 50% of assets
o Provides highest interest income for the bank
o Less liquid as cannot be turned into cash until the loan matures

Example: Net Income of Commercial Banks

Basic Banking
• Asset transformation
o Banks make profits by selling liabilities with one characteristic (combination of liquidity,
risk, size and return) and use the money to buy assets with different characteristics.
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§ E.g. providing a savings deposit to one person and using that money to provide a
mortgage loan to another
• Transformed a savings account into a mortgage loan
§ “Borrows short and lends long”

General Principles of Bank Management

Bank Management
• Liquidity Management
o Acquiring liquid assets to meet the bank’s obligations to depositors.
o When deposit outflow occurs, the bank needs to have enough reserves or liquid assets
to pay off these outflows and still meet the reserve requirement and avoid the costs of:
§ Borrowing from other banks/corporations (interest costs)
§ Selling securities (some may be illiquid)
§ Borrowing from the fed (discount interest)
§ Calling in loans early (hard to call long-term loans, some customers may leave to
another bank)
• Asset management
o Pursuing a low level of risk by acquiring assets with low default rates & diversifying
§ Finding borrowers willing to pay higher interest and unlikely to default
• Up to the bank to evaluate credit default risks
o Buying high-return & low-risk securities
o Purchasing different assets:
§ Short and long-term
§ U.S. Treasury
§ Municipal bonds
• Liability management
o Acquiring funds at a low cost
o Finding ways for liabilities to provide reserves & liquidity
o Expansion of overnight loan markets
§ Federal funds market
o Development of new financial instruments
§ Negotiable CDs
o Enabling banks to acquire funds quickly
• Capital Adequacy management
o Maintaining enough capital to profit but also enough to not fail
§ Meet depositor obligations
§ Make enough return to owners through investments
§ Meet minimum capital requirement

Main Risks
• Credit risks: borrowers may default
• Liquidity risks: unable to meet cash commitments to lenders
• Interest Rate risks: falling in net margins or asset values due to changes in interest rates
• Other Market risks: losses due to changes in exchange rates, commodity prices
• Macro risks: losses due to institutional or policy risks
• Operational risks: losses caused by errors or damages by people or system
 (6) RISK MANAGEMENT IN BANKS

Managing Credit Risk

Moral Hazard & Adverse Selection
• Borrowers with very risky investment projects have much to gain if their projects are successful,
so they are the most eager to obtain loans making it more likely bad credit borrowers will be
given loans
Screening & Monitoring
• Banks uses information to evaluate how good a credit risk you are by calculating your credit
score
o Before getting a loan, you need to fill out a form providing:
§ Salary, bank accounts & other assets (cars, insurance policies, and furnishings),
§ Outstanding loans, loan history, credit card, and account repayments
o Collects information about company net income with information about its assets &
liabilities
• Specialise in lending to local firms or one industry as easier to collect and compare information
and riskiness
• Writing provisions (restrictive covenants) in loan contracts restricting borrowers from engaging
in risky activities
o Monitoring investment projects
• Long Commitments
o Gives a business loan up to a given amount any time they need it
o Promotes long-term relationships for the bank allowing it to collect information as it
requires a continuous supply of information
• Collateral
o E.g. the house for which the mortgage loan is used for
o Reduces moral hazard because the borrower has more to lose if they default (aligns
intetests)
o Compensating balances: A firm receiving a loan must keep a required minimum amount
of funds in a checking account at the bank
• Credit rationing: refusing to make loans even though borrowers are willing to pay the stated
interest rate or even a higher rate
o Refusing to pay any amount, or only lending an amount that is lower than requested
o The lower the loan amount the lower the incentive for moral hazard

Managing Interest Rate Risk

• If a financial institution has more rate-sensitive liabilities than assets:
o A rise in interest rates will reduce the net interest margin and net worth of the
institution
o A decline in interest rates will raise the margin & net worth.
• Income Gap Analysis: estimates the sensitivity of a bank’s current year net interest income
(income - cost) to changes in interest rate
• Duration Gap Analysis: estimates the sensitivity of the net worth in market values of a ban
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Income Gap Analysis

To estimate the changes in a bank’s net interest income due to a change in interest rate
• ∆I: change in net interest income
• ∆IA: change in interest income (from loans)
• ∆IL: change in interest payment (for savings)
• RSA: rate-sensitive assets
• RSL: rate-sensitive liabilities
• ∆i: change in net interest rate
• GAP = RSA – RSL

Example: Income Gap

RSA = $5m + $10m + $15m + 20% × $10m = $32m (estimate… how many people will re-mortgage
so subject to interest rate changes in blue)
RSL = $5m + $25m + $5m + $10m + 10% × $15m + 20% × $15m = $49.5m

• If ∆i = 5%:
o ∆IA = RSA · ∆i = $32m × 5% = $1.6m
o ∆IL = RSL · ∆i = $49.5m × 5% = $2.475m
o ∆I = ∆IA − ∆IL = $1.6m − $2.475m = −$0.875m
OR
• Gap Analysis:
o GAP = RSA − RSL = $32.0m − $49.5m = −$17.5m
o ∆I = GAP · ∆i = $17.5m × 5% = −$0.875m

Duration Analysis
• Examines sensitivity of market value of the bank’s total assets and liabilities to the change in
interest rates
Changes in interest rates can affect long-term net interest income, and hence the net worth of a
financial institution
Duration: the average lifetime of a debt security’s stream of payments
• A coupon bond pays back earlier than the same-valued zero-coupon bond with the same time
to maturity
• Consider a series of zero-coupon bonds resembling the payment low of a coupon bond
o Thus, the effective maturity of a coupon bond: presented-value weighted average of the
time to maturity of those zero-coupon bonds
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Properties of Duration
• The longer the term to maturity of a bond is, the longer its duration
• When interest rates rise, the duration of a coupon bond falls (less time to pay back as payments
are higher)
• The higher the coupon rate on the bond is, the shorter the duration of the bond
Duration is additive: the duration of a portfolio is the value-weighted average of the durations of
the individual securities.
• To estimate the price changes of an asset due to the interest rate change:

• The greater the duration is, the greater the interest rate risk

Example: Duration
• Assume the interest rate rises from 10% to 11%.
• For total assets, the percentage changes will be:

• In values:
= − 2 .5% × ( 5+ 5 + 5 + 10 + 10 + 10
+ 15 + 10 + 25 + 5) = −$2.5mil
• For total liabilities, the percentage
changes:

• In values:
= − 0.9% × (15 + 5 + 15 + 10 + 15 + 5 + 5 + 5 + 10 + 5 +
5) = −$0.9mil

The value changes of net worth:

= −2.5 − (−0.9) = −$1.6mil
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Duration Gap and Interest Rate Risk

• Thus the net worth changes relative to the total assets will be:

• For the above example,

Evaluations
• To be completely immunised, set Gaps = 0
• Gap analyses have problems:
o Interest rates differ with time to
maturity
o Some rate-sensitive exposures
o Alternatives: e.g. Value-at-Risk
assessments