BANK

MANAGEMENT
Chapter 19
GROUP MEMBERS
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 CHAPTER OBJECTIVES

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

BANK GOALS, STRATEGY, AND GOVERNANCE
Aligning Managerial Compensation with Bank Goals
The underlying goal behind the managerial policies of a bank is to maximize the
wealth of the bank's shareholders. Banks commonly implement compensation
programs that provide bonuses to high-level managers that satisfy bank goals.
For example, stock options.

Bank Strategy

A bank's strategy involves the management of its sources of funds (liabilities) and
its uses of funds (assets).
Sources of funds = Interest Expenses
Asset structure = Interest Revenue
A bank must also manage operating risk that results from its general business
operations.
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 Financial Markets Facilitate the Bank's Strategy

Money markets, Mortage markets, Bond markets,

Futures markets, Options markets, Swaps markets

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. Banks usually
have both inside directors ( who are also managers) and outside directors, to avoid the
conflict of interests in serving shareholders.

Other forms of Bank Governance

traded banks are subject to shareholder
In addition to the board of directors, publicly
activism, particularly institutional investors.
The market for corporate control also serves as an additional form of governance, since
a bank that performs poorly may be subject to a takeover.
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 MANAGING LIQUIDITY
Management of Liabilities
Healthy banks tend to have easy access to liquidity. If the need for fund is temporary,
an increase in short-term liabilities (from the federal fund market) may be appropriate.
However, if the need is permanent, then a policy for increasing deposits of selling liquid
assets may be appropriate.
Management of Loans
By selling their loans to the secondary markets, banks can free up their capital and
satisfy their liquidity. eg, secondary mortgage market.
Use of Securitization to Boost Liquitidy
The ability to securitize assets such as automobile and mortgage loans can enhance the
bank's liquidity position. The process of securitization involves the sale of assets by the
bank to a trustee, who issues securities that are collateralized by the assets. The bank
may sill service the loans but the interest and principal payments it receives are passed
on to the investors who purchased the securities. IV BM 3 Khine Shun Lae Soe
 MANAGING INTEREST RATE RISK
Interest Revenues - Interest expenses
Net interest margin =
Assets

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).
During the period of rising interest rates, a bank's net interest margin will likely decrease if its
liabilities are more rate sensitive than its assets. Under the opposite scenario, when market
interest rates are declining over time, rates offered on new bank deposits will be affected by
the declining in interest rates.

Methods used to assess interest rate risk

Gap Analysis
Duration Analysis
Regression Analysis
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Gap Analysis

Gap = Rate-sensitive assets - Rate-sensitive liabilities

A gap of zero (or gap ration of 1.00) indicates that net interest margin should not be
significantly influenced by interest rate fluctuations.
A negative gap (or gap ration less than 1.00) indicates that a potential increase in
interest rates could reduce the net interest margin.

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Duration Measurement
To measure the sensitivity of their assets to interest rate movements.

Ct = the interest or capital payment of the asset

t = the time at which the payments are provided
k = the required rate of return on the asset

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Duration Measurement

DURAS = weighted average duration of the bank's assets

DURLIAB = weighted average duration of the bank's liabilities
AS = the market value of the bank's assets
LIAB = the market value of the bank's liabilities

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 risks.
The larger the duration gap, the more sensitive the bank should be to interest rate
movements. IV BM 3 Khine Shun Lae Soe
Regression Analysis

The regression analysis determines depending on how performance historically been

influenced by interest rate movements.

R = the bank’s stock return

Rm = the return on the market
B2 = the interest rate coefficient
µ = error term
B0, B1 , B2= regression coefficients

A positive (negative) coefficient suggests that the performance is favorably (adversely)

affected by rising interest rates. If the interest rate coefficient is not significantly different
from zero, the bank's stock returns are insulated from interest rates movements.

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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 the risk. Some banks measure interest rate risk using all 3
methods. The three method should lead to similar conclusion.

If a bank has negative gap, its average asset duration

is probably larger than liability duration and its past
performance level is probably inversely related to
interest rate movement. If a bank decides to reduce
its interest rate risk then it must consider the
methods of hedging, which are described next.

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Methods used to reduce interest rate risk
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 fund for a one-
year CD, it could provide a one-year loan or invest in a security with a one-year
maturity.

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.

Interest Rate Futures Contracts

A common method of reducing interest rate risk is to use interest rate futures
contracts, which lock the price at which specified financial instruments can be
purchased or sold on a specified future settlement date.
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Interest Rate Swaps

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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.

International Interest Rate Risk

When a bank has foreign currency balance, the strategy of matching the overall interest
rate sensitivity of assets to that of liabilities will not automatically achieve a lower
degree of interest rate risk.
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.

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MANAGING CREDIT RISK
Most of a bank’s funds are used either to make loans or to purchase debt
securities.

Measuring Credit Risk

For either use of funds, the bank is acting as a creditor and is subject to credit

provided by the bank will not be
(default) risk, or the possibility that credit
repaid.
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.
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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.

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.
At the other extreme, a bank concerned with maximizing its return could use
most of its funds to provide credit card and consumer loans.
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.
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REDUCING CREDIT RISK

When a bank’s loans are too heavily concentrated in a specific industry, it should
attempt to expand its loans into other industries.
If one particular industry experiences weakness, loans provided to other industries
will be insulated from that industry’s conditions.
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.
The country risk assessment focuses on a country’s financial and political
conditions.
Banks can eliminate loans that are causing excessive risk to their loan portfolios
by selling them in the secondary market.
Bank loans are commonly purchased by other banks and financial institutions,
such as pension funds, insurance companies, and mutual funds.
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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.
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.
A bank’s market risk is partially dependent on its exposure to interest rate
risk.
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INTEGRATED BANK MANAGEMENT
Bank management of assets, liabilities, and capital is integrated.
An integrated management approach is necessary to manage liquidity risk,
interest rate risk, and credit risk.

MANAGING RISK OF INTERNATIONAL OPERATIONS

Banks that are engaged in international banking face additional types of

risk, including exchange rate risk and settlement risk.
Some international loans allows repayment in a foreign currency, thus
allowing the borrower to avoid exchange rate risk.
International banks that engage in large currency transactions are
exposed to settlement risk, or the risk of a loss due to settling their
transactions.
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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.
Banks manage liquidity by maintaining some liquid assets
such as short-term securities and ensuring easy access to
funds (through the federal funds market).
Bank evaluation assessment can be used along with a
forecast of interest rates and economic conditions to
forecast the bank’s future performance.

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THANK YOU FOR
YOUR ATTENTATION