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EC 324 ch. 9

Terms in this set (22)

Libailties
- checkable deposits
- Nontransaction deposits
- borrowings
- bank capital
Assets
- reserves
- cash items in process of collection
- deposits at other banks
- securities
- loans
- other assets
Return on Assets
ROA = net profit after taxes/ assets

(net profit after taxes per dollar of assets)
Return on Equity
ROE = net profit after taxes/ equity capital

(net profit after taxes per dollar of equity capital)
Equity Multiplier
EM = Assets/ Equity Capital

(the amount of assets per dollar of equity capital)
ROE = ROA x EM
(net profit after taxes/ equity capital) = (net profit after taxes / assets) x (assets/equity capital)
Asset Management: Four Tools
1. Final borrowers who will pay high interest rates and have low possibility of defaulting

2. Purchase securities with high returns a low risk

3. Lower risk by diversifying

4. Balance the need for liquidity against increased returns from less liquid assets
Asset Management: Three Goal
1. Seek the highest possible returns on loans and securities

2. Reduce risk

3. Have adequate liquidity
Capital Adequacy Management
- bank capital helps prevent bank failure

- the amount of capital affects return for the owners (equity holders) of the bank

- regulatory requirement
Managing Credit Risk
1. Screening & Monitoring
- screening
- specialization in lending
- monitoring and enforcement of restrictive covenants

2. Long-term customer relationships
3. loan commitments
4. collateral and compensating balances
5. credit rationing
Gap and Duration Analysis (basic)
(rate sensitive assets - rate sensitive liabilities) x Delta Interest Rates = Delta in bank profit

accounts for different degrees of rate sensitivity
Asset Transformation
When banks make profits by selling liabilities with one set of characteristics (a particular combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a different set of characteristics
Reserves
Consists of the deposits plus currency that is physically held by banks [in vaults]
Required Reserves
Some reserves that are held in the bank because of requires the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves. This fraction is known as
Excess Reserves
Banks hold additional reserves because they are the most liquid of al bank assets, and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account
When a deposit outflow occurs, excess reserves enable the bank to escape the cost of:
1. borrowing from other banks or corporations
2. selling securities
3. borrowing from the Fed
4. Calling in or selling off loans
Discount Rate
The cost associated with discount loans is the interest rate that must be paid to the Fed
Rationale for a bank to maintain sufficient level of capital
A bank maintains bank capital to lessen the chance that it will become insolvent
Why not too much capital?
Given the return on assets, the lower the bank capital, the high the return for the owners of banks
Duration Analysis
- (Da - Dl x l/a) x delta interest x A

where: Da = Duration of Assets
Dl = Duration of Liabilities
l = liabilities
a (or A)= assets
Net worth (in relation to Duration Model)
NW = TA - TL
Off-Balance sheet activities
1. loan sales (secondary loan participation)
2. generation of fee income
- servicing mortgage-backed securities
- creating SIVs (structured investment vehicles) [can expose banks to risk - it happened during the global financial crisis]
3. trading activities and risk management techniques
- financial futures, options for debt instruments, interest rate swaps, transactions in the FOREX market and speculation
- principal-agent problem arises
4. Internal controls to reduce the principal-agent problem
- separation of trading activities and bookkeeping
- limits on exposure
- value-at-risk
- stress testing


These activities expose banks to increased risk, bank management must pay particular attention to risk assessment procedure and internal controls to restrict employees from taking on too much risk
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