C HA PTER 7 : BA NK

R I S KS A ND B A N K R I S K
M A NAG EMENT
OUTLINE
• Principles of bank management

• Bank risk management

• Measuring risk
BANK MANAGEMENT AIMS
• A bank’s objective is to maximize profit while remaining ‘safe and
sound’:
– Must manage assets and liabilities to achieve maximum profit
• Asset management aims at:
– Earning highest possible return from assets at a minimal level of risk:
• risk of individual assets (e.g. loans) minimized
• well diversified portfolio of assets
– Utilize methods such as credit risk and interest rate risk management
• Liability management aims at:
– Acquiring funds at lowest cost
BANK MANAGEMENT AIMS
• Liquidity management
– Banks must be able to meet deposit outflows
– Involves predicting daily withdrawals and keeping sufficient cash to meet
them
• Capital adequacy management
– bank must be able to sustain some loan losses to remain solvent
– meet regulator’s demands (Basle Accord stipulates a ratio of 8% of bank
capital to assets)
• Off‐balance sheet (OBS) management
– Bank must control and limit exposures from off‐balance sheet
transactions (e.g. derivative instruments)
– OBS generate ‘contingent’ liabilities, in extreme circumstances may result
in a bank failing (e.g. Barings Bank)
PRINCIPLES OF BANK MANAGEMENT
Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million
Assets Liabilities
Reserves $20 million Deposits $100 million
Loans $80 million Bank Capital $10 million
Securities $10 million
Deposit outflow
- 10 m Deposit outflow of $10 million - 10 m
Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $80 million Bank Capital $10 million
Securities $10 million

• With 10% reserve requirement, bank still has excess reserves of $1

million: no changes needed in balance sheet
LIQUIDITY MANAGEMENT
No excess reserves
Assets Liabilities
Reserves $10 million Deposits $100 million
Loans $90 million Bank Capital $10 million
Securities - 10 m $10 million - 10 m
Deposit outflow of $10 million
Assets Liabilities
Reserves $0 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities $10 million

• With 10% reserve requirement, bank has $9 million reserve

shortfall
LIQUIDITY MANAGEMENT
1. Borrow from other banks or corporations
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Borrowings $9 million +9m

Securities $10 million Bank Capital $10 million

2. Sell securities
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities - 9m $1 million
LIQUIDITY MANAGEMENT
3. Borrow from Fed
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Discount Loans $9 million +9m

Securities $10 million Bank Capital $10 million

4. Call in or sell off loans

Assets Liabilities
Reserves + 9 m $9million Deposits $90 million
Loans - 9 m $81 million Bank Capital $10 million
Securities $10 million

• Excess reserves are insurance against above 4 costs from deposit

outflows
ASSET MANAGEMENT
• A bank’s asset portfolio can be thought of as an ordinary
portfolio of assets with different risk‐return characteristics
– Applying modern portfolio theory suggests deriving an efficient portfolio
frontier in the risk‐return space (diversification to eliminate idiosyncratic
risk)

• Choosing among efficient portfolios according to attitude

towards risk
• However, risk of individual assets is unknown because of
imperfect information → credit risk analysis
CREDIT RISK
• Basel Committee on Banking Supervision defines
credit risk as:
– “the potential that a bank borrower or counterparty
will fail to meet its obligations in accordance with
agreed terms.”
– More simply, it is the risk that a loan is not repaid (in
part or in full)
• Banks face credit risk not only for loans but also
for OBS instruments like derivatives, where it is
known as ‘counterparty risk’.
CREDIT RISK MANAGEMENT
• Adverse selection and moral hazard are endemic in
credit markets. To address them banks engage in:
– Screening loan applicants
– Monitoring and restrictive covenants
– Specialization in lending
– Long‐term customer relationships
– Collateral and compensating balances
– Credit rationing
LIABILITY MANAGEMENT
• Liability Management: managing the source of
funds, from deposits, to CDs, to other debt.
– Importance has grown dramatically
– No longer primarily depend on deposits
– Borrow or issue CDs to acquire funds
INTEREST RATE RISK
First National Bank
Assets Liabilities ($m)
Rate-sensitive assets Rate-sensitive liabilities
£200M £500M
Variable rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets Fixed-rate liabilities
£800M £500M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital

If the bank has more rate-sensitive liabilities than assets, a rise in

interest rates will reduce bank profits and a decline in interest rates will
raise bank profits
HOW DO BANKS MANAGE
INTEREST RATE RISK
• Gap analysis
– Subtract the amount of interest rate-sensitive liabilities form the amount
of interest rate-sensitive assets
– Multiply the gap by the change in interest rate
• Obtain the effect on profit

• Maturity bucket approach

– Basic gap analysis useful for illustrative purposes
– In reality, assets and liabilities have different maturities
– Carry out gap analysis at each maturity
MEASURING INTEREST RATE RISK
IN PRACTICE
Maturity Assets Liabilities Incremental Cumulative INTEREST
(£m) (£m) GAP (£m) GAP (£m) RATE RISK
(annualised)
+5% -5%
0-7 days 10 15 -5 -5 -0.25 +0.25
7-90 days 20 260 -240 -245 -12.25 +12.25
3-12months 50 385 -335 -580 -29.00 +29.00
1-2 years 120 200 -80 -660 -33.00 +33.00
2-5 years 300 60 240 -420 -21.00 +21.00
5+ years 500 80 420 0 0.00 0.00
Total 1000 1000
USING DERIVATIVES TO MANAGE
INTEREST RATE RISK
• Matching assets and liabilities has disadvantages:
– It is a costly way of managing interest rate risk
– Prevents banks from issuing fixed interest rate loans, which
are attractive to customers
• Interest rate swaps offer a better alternative:
– Can convert fixed rate assets into rate sensitive assets at
relatively low transaction costs
– Consider the hypothetical balance sheet:
• Assume it corresponds to Bank A
• Assume there is a Bank B that has £200m variable‐rate loans
it wants to convert to 5‐year fixed‐rate loans.
AN INTEREST RATE SWAP
• Bank A has £200m of 5-year fixed rate loans, which it wants to swap
for £200m of variable rate loans
• Bank B has £200m of variable rate loans, which it wants to swap with
5-year fixed rate loans
• An intermediary matches Bank A and Bank B, for a fee
• The Banks enter a contract to exchange interest payments on a
notional principal of £200m swap interest payments

Fixed rate over 5 year period

At 7% p.a. £200m

Bank A Bank B
Variable rate (bank rate + 1%)
£200m for 5 years
MARKET RISK AND VAR
• VaR attempts to answer the following question:
– How much money could the bank lose from its portfolio of
securities over the next week/month/year with a given
probability
– VaR is a useful summary measure for both bank managers
and regulators
– Its usefulness depends on the accuracy of calculations.
– Useful as a measure of risk for the bank’s portfolio of
securities
OPERATIONAL RISK

• Basel Committee defines operational risk as:

– “the risk of loss resulting from inadequate or failed internal processes, people and systems
or from external events”

• It is very hard to quantify as it captures a whole range of internal and

external factors such as: failure of computer systems, rogue traders or
genuine human error…
 QUIZ
• Define Bank Capital

• Explain the advantages and disadvantages of

maintaining a large amount of bank capital.

• Discuss the advantages and disadvantages of using

an interest rate swap contract.
CAPITAL ADEQUACY MANAGEMENT
• Bank capital is a cushion that prevents bank failure
• Consider these two banks:

High Capital Bank

Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $90 million Bank Capital $10 million

Low Capital Bank

Assets Liabilities
Reserves $10 million Deposits $96 million
Loans $90 million Bank Capital $4 million
CAPITAL ADEQUACY MANAGEMENT

• What happens if these banks make loans or invest in securities (say,

subprime mortgage loans, for example) that end up losing money?
Let’s assume both banks lose $5 million from bad loans.
CAPITAL ADEQUACY MANAGEMENT
Impact of $5 million loan loss
High Capital Bank
Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $85 million Bank Capital $5 million

Low Capital Bank

Assets Liabilities
Reserves $10 million Deposits $96 million
Loans $85 million Bank Capital -$1 million

• A bank maintains capital to lessen the chance

that it will become insolvent.
CAPITAL ADEQUACY MANAGEMENT
Why don’t banks want to hold a lot of capital?
• Higher is bank capital, lower is return on equity
– ROA = Net Profits/Assets
– ROE = Net Profits/Equity Capital
– EM = Assets/Equity Capital
– ROE = ROA  EM
– Capital , EM , ROE 
CAPITAL ADEQUACY MANAGEMENT
• Tradeoff between safety (high capital) and ROE
• Banks also hold capital to meet capital requirements
– The Basel Committee on Banking Supervision sets minimum
capital requirements — the ratio of bank capital to risk
weighted assets
AN UNDER-CAPITALISED BANK
FACES LOAN DEFAULT

Assets (£m) Liabilities (£m)

Reserves 50 Deposits 700
Cash at Vault 10
Deposits with CB 40
Loans 740 Bank capital 40
Loan loss reserves 20
Shareholder’s capital 30

Securities 0 Borrowings from 50

Treasury Bills 0 other banks
Other bonds 0
MEASURING AND EVALUATING
BANK PERFORMANCE
• Bank’s long-term objective: maximizing the value of
the firm
• Value of the bank’s stock = Expected stream of future
stockholder dividends/Discount factor
• If the dividends a bank pays its stockholders are
expected to grow at a constant rate g over time:
P0 = D1/(r-g)
PROFITABILITY RATIOS
• Return on Equity capital (ROE) = Net income after taxes/ Total equity capital
(1)
• Return on Assets (ROA) = Net income after taxes/ Total assets (2)
• Net interest margin = (Interest income from loans and security investments –
Interest expense on deposits and on the other debt issued)/Total assets (3)
• Net noninterest margin = (Noninterest revenues – Noninterest expenses)/Total
assets (4)
• Net bank operating margin = (Total operating revenues – Total operating
expenses)/Total assets (5)
• Earnings per share (EPS) = Net income after taxes/Common equity shares
outstanding (6)
• Earnings spread = Total interest income/Total earning assets – Total interest
expense/Total interest-bearing bank liabilities (7)
CLOSER ANALYSIS
• ROE = ROA × Total assets/Total equity capital (8)
• ROE = [(Total revenues – total operating expenses – taxes)/Total
assets] × Total assets/Total equity capital
• ROE = (Net income after taxes/Total Operating revenue) × (Total
operating revenue/Total assets) × (Total assets/Total equity capital)
• ROE = Net profit margin (NPM) × Asset utilization ratio (AU)×
Equity multiplier (EM) (9)
MEASURING RISK

• Credit risk
• Liquidity risk
• Market risk
• Interest rate risk
• Earning risk
• Solvency risk
CREDIT RISK
• Nonperforming assets/Total loans and leases
• Net charge-offs of loans/Total loans and leases
• The annual provision for loan losses/Total loans
and leases (or equity capital)
• Allowance for loan losses/Total loans and leases
(or equity capital)
• Total loans/ total deposits
LIQUIDITY RISK
• Purchases funds (Eurodollars, federal funds,
security RPs, large CDs, commercial paper/ Total
assets
• Net loans/ Total assets
• Cash and due-from deposit balance held at other
banks/ Total assets
• Cash assets and government securities/ Total
assets
MARKET RISK
• A bank’s book-value assets/ Estimated market value
• Book-value equity capital/ market value of a bank’s equity
capital
• The market value of a bank’s bonds and other fixed-
income assets/ Value as recorded on the bank’s books
• The market value of a bank’s common and preferred
stock per share
INTEREST RATE RISK
• Interest sensitive assets/Interest sensitive liabilities
• Uninsured deposits/Total deposits
SOLVENCY (DEFAULT) RISK
• The interest rate spread between market yields on bank
debt issues and the market yields on government
securities of the same maturity
• Bank’s stock price/EPS
• Equity capital (net worth)/Total assets
• Purchased funds/Total liabilities
• Equity capital/Risk assets (loans and securities and exclude
cash, plant and equipment, and miscellaneous assets)
OTHER FORMS OF RISK
• Inflation risk
• Currency or exchange rate risk
• Crime risk
• Political risk