C12: Banking and the Management of Financial Institutions

What is the basic balance sheet identity?

Assets = Liabilities + Capital

What are bank assets?

Uses of funds that generate income (loans, securities, reserves)

What are bank liabilities?

Sources of funds (deposits, borrowings)

What is bank capital?

Net worth = Assets − Liabilities

Why is bank capital important?

It provides a cushion against losses and prevents insolvency

What is insolvency?

When liabilities exceed assets

What are the main sources of bank funds?

Deposits, borrowings, and capital

What are the main uses of bank funds?

Loans, securities, and reserves

Why are loans the largest share of bank assets?

They generate the highest returns

What are chequable deposits?

Deposits withdrawable on demand used for payments

What are fixed-term deposits?

Deposits with restricted withdrawal and higher interest rates

What are bank borrowings?

Funds borrowed from central bank, other banks, or corporations

What is liquidity management?

Holding liquid assets to meet withdrawal demands

What is asset management?

Maximizing returns while minimizing risk and maintaining liquidity

What is liability management?

Acquiring funds at the lowest possible cost

What is capital adequacy management?

Maintaining sufficient capital to prevent insolvency and meet regulations

Why don’t banks hold only reserves if they are safest?

Because reserves earn very low returns, reducing profitability

A bank increases loans and reduces reserves. What happens?

Profit increases, liquidity decreases, and risk increases

A bank increases securities instead of loans. What happens?

Liquidity increases, risk decreases, but returns are lower

A bank experiences deposit outflows. What is the first response?

Use excess reserves

Why are reserves considered insurance?

They prevent costly adjustments during withdrawals

What are the four responses to deposit outflows (best to worst)?

Use reserves → borrow → sell securities → call in loans

Why is calling in loans costly?

It damages customer relationships and future business

A bank has no excess reserves and faces withdrawals. What can it do?

Borrow funds or sell securities (both involve costs)

What is credit risk?

The risk that borrowers default

What is adverse selection?

Risky borrowers are most likely to seek loans

What is moral hazard?

Borrowers take more risk after receiving a loan

Why is adverse selection a problem?

Banks may lend to borrowers most likely to default

Why is moral hazard a problem?

Borrowers may engage in activities that increase default risk

What is screening?

Evaluating borrowers before lending

What is monitoring?

Tracking borrower behavior after lending

Why is screening not enough?

Borrowers can change behavior after receiving funds

What are restrictive covenants?

Loan contract terms that limit risky behavior

How do covenants reduce risk?

They restrict borrower actions and allow enforcement

Why do banks monitor borrowers?

To reduce moral hazard and enforce loan conditions

Why do banks specialize in lending?

To improve information and screening accuracy

What are long-term customer relationships?

Ongoing relationships that provide borrower information

How do long-term relationships reduce risk?

Lower screening costs and discourage risky behavior

What is a loan commitment?

A promise to lend up to a certain amount in the future

Why are loan commitments useful for banks?

They generate fees and improve information gathering

What is collateral?

Assets pledged to the lender if the borrower defaults

How does collateral reduce adverse selection?

Only borrowers with assets qualify

How does collateral reduce moral hazard?

Borrowers risk losing assets if they default

What are compensating balances?

Required deposits held at the bank by borrowers

How do compensating balances help?

Act as collateral and allow monitoring of financial activity

What is credit rationing?

Limiting or denying loans even if borrowers will pay higher rates

Why don’t banks just charge higher interest rates?

It worsens adverse selection by attracting riskier borrowers

Why do banks limit loan size?

To reduce incentives for moral hazard

What is interest-rate risk?

The risk that changes in interest rates affect earnings and asset values

What are rate-sensitive assets/liabilities?

Assets or liabilities whose interest rates adjust frequently

What are fixed-rate assets/liabilities?

Assets or liabilities with stable interest rates

A bank has more rate-sensitive liabilities than assets. What happens if rates rise?

Profits decrease

A bank has more rate-sensitive liabilities than assets. What happens if rates fall?

Profits increase

What is gap analysis?

GAP = rate-sensitive assets − rate-sensitive liabilities

Calculate GAP: RSA = 50, RSL = 80

GAP = −30

How do you calculate change in profits using GAP?

GAP × change in interest rates

If GAP = −30 and rates rise by 2%, what happens?

Profit change = −30 × 0.02 = −0.6 (profits fall)

What does a negative GAP mean?

Liabilities are more rate-sensitive than assets

What is duration?

The average time to receive cash flows

What is duration analysis?

Measuring sensitivity of asset/liability values to interest rates

A bank has longer-duration assets than liabilities. What happens if rates rise?

Net worth decreases

Why is duration analysis better than gap analysis?

It considers changes in market value, not just income

How can banks reduce interest-rate risk?

Adjust asset/liability structure or use derivatives

What are financial derivatives?

Instruments like futures, options, and swaps used for risk management

What is the trade-off in capital management?

Higher capital increases safety but lowers ROE

What is ROE?

Return on equity = profit per dollar of equity

What is ROA?

Return on assets = profit per dollar of assets

What is the equity multiplier?

Assets divided by equity

What is the relationship between ROE and ROA?

ROE = ROA × Equity Multiplier

If capital decreases (holding ROA constant), what happens to ROE?

ROE increases

Why do banks prefer lower capital?

It increases returns to shareholders

Why do regulators require capital?

To reduce the risk of bank failure

What happens when banks face capital shortfalls?

They reduce lending and shrink assets

What is a credit crunch?

A reduction in lending due to capital shortages

What are off-balance-sheet activities?

Activities that generate income but do not appear on the balance sheet

Why are off-balance-sheet activities attractive?

They generate fees without increasing assets

What is a loan sale?

Selling loan cash flows to remove them from the balance sheet

How do banks profit from loan sales?

Selling loans at slightly higher prices

What is fee income?

Income earned from services instead of interest

Give examples of fee-based activities

Foreign exchange, loan servicing, guarantees

What are backup lines of credit?

Commitments to lend in the future

Why are loan commitments risky?

Banks may be forced to lend under poor conditions

What are standby letters of credit?

Guarantees backing securities

Why do guarantees increase risk?

Banks must pay if borrowers default

What are trading activities?

Transactions in derivatives, securities, and foreign exchange

Why are trading activities risky?

Large positions can lead to significant losses quickly

What is speculative trading?

Trying to profit from predicting market movements

What is the principal-agent problem in trading?

Traders take excessive risk because they gain from success but losses fall on the bank

How do banks control trading risk?

Internal controls, limits, and monitoring systems

What is Value-at-Risk (VaR)?

The maximum expected loss over a given time period

What is stress testing?

Simulating extreme scenarios to assess losses

What is the main trade-off in banking overall?

Maximizing profit while managing risk (liquidity, credit, interest-rate, capital)

A bank increases loans, reduces capital, and expands aggressively. What risks increase?

Credit risk, liquidity risk, and insolvency risk

A bank funds long-term loans with short-term deposits. What risk arises?

Interest-rate risk

A bank lends heavily to one industry. What risk principle is violated?

Diversification

Why is banking called “the business of information”?

Because success depends on collecting and analyzing borrower information