Principles of Banking & Management

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PART III

Financial Institutions

with higher interest rates. As mentioned earlier, this process of asset transformation is frequently described by saying that banks are in the business of “borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a 5% interest rate and it costs another $3 per year to service the account, the cost per year of these deposits is $8. The bank’s profit on the new deposits is then $1 per year (a 1% return on assets).

General Principles of Bank Management

The decisions made
acquisition of
A bank’s deposits
Losses of decision by
a bankthe maintainof
assetsat low cost a low
about that have to
when depositors make
funds to amount
sufficient shouldassets
rate of default demand
capital it liquid
withdrawals or and
increase profits.
to meet the bank’s
diversification of asset
maintain
payment. and then
obligations to the
holdings to increase
acquisition of
depositors.
profits. capital.
needed

The risk arising from
possible reduction
in returns associated
the possibility that the
with changes in interest
borrower will default.
rates.

Liquidity
Management
and the Role of
Reserves

Now that you have some idea of how a bank operates, let’s look at how a bank manages its assets and liabilities in order to earn the highest possible profit. The bank manager has four primary concerns. The first is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows, that is, when deposits are lost because depositors make withdrawals and demand payment. To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors. Second, the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). The third concern is to acquire funds at low cost (liability management). Finally, the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management). To understand bank and other financial institution management fully, we must go beyond the general principles of bank asset and liability management described next and look in more detail at how a financial institution manages its assets. The two sections following this one provide an in-depth discussion of how a financial institution manages credit risk, the risk arising because borrowers may default, and how it manages interest-rate risk, the riskiness of earnings and returns on bank assets that results from interest-rate changes.

Let us see how a typical bank, the First National Bank, can deal with deposit outflows that occur when its depositors withdraw cash from checking or savings accounts or write checks that are deposited in other banks. In the example that follows, we assume that the bank has ample excess reserves and that all deposits have the same required reserve ratio of 10% (the bank is required to keep 10% of its time and checkable deposits as reserves). Suppose that the First National Bank’s initial balance sheet is as follows:

Assets
Reserves
Loans
Securities

Liabilities
$20 million
$80 million
$10 million

Deposits
Bank capital

$100 million
$ 10 million

The bank’s required reserves are 10% of $100 million, or $10 million. Since it holds $20 million of reserves, the First National Bank has excess reserves of $10 million. If a deposit outflow of $10 million occurs, the bank’s balance sheet becomes:

CHAPTER 9

Banking and the Management of Financial Institutions

Assets
Reserves
Loans
Securities

209

Liabilities
$10 million
$80 million
$10 million

Deposits
Bank capital

$90 million
$10 million

The...
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