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Chapter 19 Bank Management Outline Bank Goals, Strategy, and Governance Bank Alignment of Compensation with Goals Bank Strategy Bank Governance by the Board of Directors Other Forms of Bank Governance Managing Liquidity Management of Liabilities Management of Money Market Securities Management of Loans Use of Securitization to Boost Liquidity Managing Interest Rate Risk Methods Used to Assess Interest Rate Risk Whether to Hedge Interest Rate Risk Methods Used to Reduce Interest Rate Risk International Interest Rate Risk Managing Credit Risk Measuring Credit Risk Tradeoff between Credit Risk and Expected Return Reducing Credit Risk Managing Market Risk Measuring Market Risk Methods Used to Reduce Market Risk Integrated Bank Management Application Managing Risk of International Operations Exchange Rate Risk Settlement Risk Key Concepts 1. Create a simple example of how banks that attempt to maximize returns can be exposed to a high degree of liquidity risk, interest rate risk, and default risk. 2. Describe liquidity risk, and explain how banks manage it. 3. Describe interest rate risk, and explain how banks manage it. 4. Describe credit risk, and explain how banks manage it. 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. ANSWER: Many arguments are possible. A bank may be able to avoid a large amount of loan defaults by providing loans to only the highest rated firms. However, many banks would not be able to lend all the funds that they have if they only lend to the highest rated firms. Therefore, they provide some loans to weaker firms, and are susceptible to loan defaults when economic conditions are weak. There are many banks competing to give loans and it causes some banks to provide loans that are questionable. The competition is good for the industry because it ensures that deserving customers can receive funding at a competitive rate, but it leads to some bank failures. Questions 1. Integrating Asset and Liability Management. What is accomplished when a bank integrates its liability management with its asset management? ANSWER: Integrating asset and liability decisions can improve performance. For example, the decision to focus on short-term CDs as a source of funds may result in a decision to concentrate on rate-sensitive assets, such as floating-rate loans. This strategy reduces interest rate risk. 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? ANSWER: Treasury bill yields are sometimes lower than a bank’s cost of obtaining funds. Thus, banks should not concentrate their investment in Treasury bills. 3. Illiquidity. How do banks resolve illiquidity problems? ANSWER: Banks can resolve illiquidity by selling some assets to obtain funds, or borrowing funds in the federal funds market or from the discount window. 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? ANSWER: It may increase its concentration of rate-sensitive liabilities and reduce its concentration of rate-sensitive assets. 5. Rate Sensitivity. List some rate-sensitive assets and some rate-insensitive assets of banks. ANSWER: Rate-sensitive assets include floating-rate loans and short-term securities. Rate-insensitive assets include long-term fixed-rate loans and long-term securities. 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? ANSWER: It can attempt to match the degree of rate sensitivity of assets and liabilities, through maturity matching, interest rate futures contracts, or interest rate swaps. 7. Net Interest Margin. What is the formula for the net interest margin? Explain why it is closely monitored by banks. ANSWER: The net interest margin is closely monitored by banks because it usually is the primary contributor to the bank’s return on assets. 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? ANSWER: It could use floating-rate loans, so that its assets are rate-sensitive even with long-term maturities. 9. Bank Exposure to Interest Rate Movements. According to this chapter, have banks been able to insulate themselves against interest rate movements? Explain. ANSWER: Banks can attempt to minimize their exposure to interest rate risk because they have the flexibility to use assets whose rate sensitivity is similar to the liabilities. Yet, banks are unable to perfectly match the rate sensitivity of assets and liabilities. Research has found that bank values are typically inversely related to interest rates. 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? ANSWER: A bank gap is measured to determine its exposure to interest rate risk. A negative gap implies that a bank would be adversely affected by rising interest rates, since the value of rate-sensitive liabilities exceeds the value of rate-sensitive assets. Value of Value of Gap = rate-sensitive – rate-sensitive assets liabilities It is difficult to classify some assets or liabilities as rate sensitive or rate insensitive, since the degree of rate sensitivity may vary within a given classification. 11. Duration. How do banks use duration analysis? ANSWER: Banks measure duration of assets and liabilities so that they can determine whether their assets are more or less rate-sensitive than their liabilities. 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? ANSWER: A fixed-rate loan may be perceived as rate insensitive. Yet, if it is prepaid, the funds are loaned out to someone else at the prevailing rate. Therefore, this type of loan can be sensitive to interest rates. 13. Bank Management Dilemma. Can a bank simultaneously maximize return and minimize default risk? If not, what can it do instead? ANSWER: Banks cannot maximize return unless they incur some default risk, so they must balance the risk and return objectives, based on their degree of risk aversion. 14. Bank Exposure to Economic Conditions. As economic conditions change, how do banks adjust their asset portfolio? ANSWER: Expectations of a stronger economy may encourage banks to provide more risky loans, since the probability of default may decrease, and the potential return is higher. Expectations of a weaker economy may encourage banks to use a more conservative approach. Expectations of higher (lower) interest rates encourage banks to have more rate sensitive assets (liabilities). 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. ANSWER: Banks should diversify across geographic regions and industries, to reduce exposure to specific events. Not necessarily. If the countries receiving loans tend to experience similar business cycles, international diversification of loans has only limited effectiveness. International diversification of loans to creditworthy borrowers has some merit, but the creditworthiness criterion should not be ignored just to achieve international diversification. 16. Commercial Borrowing. Do all commercial borrowers receive the same interest rate on loans? ANSWER: Interest rates on loans at a given point in time are dependent on the degree of risk of the borrower. 17. Bank Dividend Policy. Why might a bank retain some excess earnings rather than distribute them as dividends? ANSWER: Banks retain earnings as a source of capital. 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? ANSWER: During a period of rising interest rates, the bank’s net interest margin will decline. During a period of declining interest rates, the bank’s net interest margin will increase. 19. Floating-Rate Loans. Does the use of floating-rate loans eliminate interest rate risk? Explain. ANSWER: The use of floating-rate loans may reduce interest rate risk, but not eliminate it, because the rate sensitivity on assets will still not match up perfectly with the rate sensitivity on liabilities. 20. Managing Exchange Rate Risk. Explain how banks become exposed to exchange rate risk. ANSWER: When banks accept deposits in one currency and provide loans in a different currency, they are exposed to exchange rate risk. Banks whose currency composition of assets differs from the currency composition of liabilities are exposed to exchange rate risk. Banks may also become exposed if they offer forward contracts that are not offset by opposite commitments. Advanced Questions 21. Bank Exposure to Interest Rate Risk. Oregon Bank has branches overseas that concentrate in 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. ANSWER: U.S. interest rates will not necessarily move in tandem with British interest rates, thus, it is possible that British interest rates will decline while U.S. interest rates remain stable or rise. In this case, the bank will be adversely affected by interest rate movements. Oregon Bank has not eliminated its interest rate risk. 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. ANSWER: Dakota Bank is susceptible to interest rate movements. If Swiss interest rates rise, the bank’s cost of funds increases. If U.S. interest rates decline, the bank’s interest revenues would decline. The two scenarios described above could occur simultaneously, causing lower earnings for Dakota Bank. 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. ANSWER: The strategy could backfire if the Swiss franc appreciates against the dollar over time, because some of the dollars received from loan repayments etc. would have to be converted into Swiss francs to repay the deposits denominated in francs. 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. ANSWER: One disadvantage is that the bank may not be able to satisfy some potential borrowers who desire a loan denominated in some other currency. For example, if the bank receives mostly dollar deposits over the next month, it could not accommodate firms that need to borrow francs. Therefore, it would forgo some business because of its desire to avoid exchange rate risk. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The bank’s biggest mistake was that it did not recognize that its forecast of a strong local real estate market and declining interest rates could be wrong.” The bank apparently tried to capitalize on expectations of a strong real estate market by allocating a large amount of funds to real estate loans. It also apparently created a negative gap to benefit from an expected decline in interest rates. Since its forecast was wrong, its performance was poor. b. “Banks still need some degree of interest rate risk to be profitable.” If banks attempted to perfectly match the maturities of the liabilities with maturities of their assets, the interest rate spread might not be sufficient to cover their own expenses. Thus, they can benefit from an upward-sloping yield curve by borrowing short term and lending long term, assuming that interest rates do not increase substantially. In some periods when there is a threat of rising interest rates, they may partially hedge their interest rate risk. Yet, they will not hedge all their interest rate risk because it limits the potential returns. 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.” When interest rates rise, demand for the bank’s loans decline. Therefore, the bank’s profits are reduced when the loan demand rises. Managing in Financial Markets 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 + 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? Stetson’s overall spread is derived as follows: Year 1 Year 2 Year 3 Year 4 Year 5 Average rate earned on assets 11% 11% 11% 11% 11% Fixed swap outflow payments 10 10 10 10 10 Difference 1 1 1 1 1 LIBOR 7 6 8 10 8 Variable-rate swap inflow payment 8 7 9 11 9 Cost of funds 6 5 7 9 7 Difference 2 2 2 2 2 Overall spread 3 3 3 3 3 Stetson should not use an interest rate swap because its expected spread is more favorable in most years if it does not hedge. 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. Stetson could use sensitivity analysis to determine its performance based on a variety of possible interest rate scenarios. It might even develop a probability distribution of outcomes that could be derived from a probability distribution of interest rate scenarios. 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. No. Stetson needs to accommodate the needs of its borrowers. If the borrowers prefer fixed-rate loans, Stetson should provide fixed-rate loans, and hedge the interest rate risk in some other manner . 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? ANSWER: 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? ANSWER: 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? ANSWER: 4. Managing Risk. Use the balance sheet for San Diego Bank in Exhibit A (below and next page) and the industry norms in Exhibit B (page following Exhibit A) to answer the following questions: a. Estimate the gap and determine how San Diego Bank would be affected by an increase in interest rates over time. ANSWER: Gap = Rate-sensitive assets – Rate-sensitive liabilities = $0 – $18 billion = –$18 billion The bank would be adversely affected by rising interest rates. b. Assess San Diego Bank’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? ANSWER: The bank has a greater proportion of commercial and consumer loans than the industry average, and therefore appears to have greater default risk. 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. ANSWER: The bank could reduce its interest rate risk by using floating-rate loans and by trying to attract some funds through medium-term (one- to five-year) CDs. It could reduce the default risk by restructuring its asset portfolio to contain more Treasury and municipal securities, less consumer loans, and less commercial loans.

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? ANSWER: The coefficient for the market variable is 0.38, while the coefficient for the interest rate variable is –1.15. The t-statistics for the coefficients suggest significance at the 0.10 level for the market variable, and at the 0.05 level for the interest rate variable. The R-Squared statistic is about 0.75, which suggests that 75 percent of the variation in Montana’s stock returns can be explained by the market and interest rate variables. The sign of the interest rate coefficient is negative, which implies a negative relationship between the interest rate movements and the stock returns of Montana Bank. Therefore, Montana Bank would be concerned about a potential increase in interest rates. Some models use the change in the interest rate level rather than the interest rate level itself, but this example simply illustrates how the bank could assess exposure to economic variables. 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. 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? First, some banks may be more optimistic about economic conditions than other banks, and therefore expect that the strong economy will generate more sales for the firm in the future. Second, even if banks assess a given firm as having the same probability of defaulting on the loan, some banks may be willing to provide the loan while others may not. This is because banks have different threshold levels depending on their management style. A bank may be willing to take more risk than others, because it is striving for higher income and therefore higher returns for its shareholders. 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 uses to establish its business. It channels bank deposit funds, which are insured by the 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? The bank is monitored by its shareholders. It is probably taking the risk that is desired by its shareholders. Yet, the FDIC may need to intervene if the bank experiences financial problems. The FDIC attempts to prevent excessive risk-taking by forcing banks with riskier asset portfolios to maintain more capital, and this effectively reduces the return on the bank’s capital. However, the bank can charge higher interest rates on its risky loans, which may satisfy the bank’s shareholders. The point is that the objectives of the depositors, bank shareholders, and bank regulators all have a different perspective. Thus, the bank managers serve bank shareholders within the constraints enforced by bank regulators. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172

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