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					                                       Chapter 19

                              Bank Management
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.

202  Chapter 19/Bank Management

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.

                                                  Interest revenue – Interest expenses
                        Net interest margin =

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

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?
                                                                          Chapter 19/Bank Management  203

    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 solution to 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.
204  Chapter 19/Bank Management

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

17. Bank Dividend Policy. Why might a bank retain some excess earnings rather than distribute them as

    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. Asian Crisis. Explain why bank decision making is sometimes blamed for the Asian crisis.

    ANSWER: Bank credit was literally provided to some firms that did not deserve credit. Once
    economic conditions deteriorated, those firms experienced financial problems.

21. 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 differ 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.

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?

                                                Interest revenues – Interest expenses
                       Net interest margin =

                                                $201 million – $156 million
                                                         $800 million

                                             5.625%
                                                                        Chapter 19/Bank Management  205

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?

                                               net profit after taxes
                                    ROA =
                                                      total assets

                                               $169 million
                                                $17 billion

                                            . 99 %

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?
206  Chapter 19/Bank Management

                                                net profit after tax
                                     ROE =


                                             12.5%

4. Managing Risk. Use the balance sheet for San Diego Bank in Exhibit A (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.

                               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.
                                                              Chapter 19/Bank Management  207

                       Exhibit A: Balance Sheet for San Diego Bank
                                  (in Millions of Dollars)

                   Assets                                   Liabilities and Capital

Required                             $800           Demand Deposits                      $800

Commercial                                          NOW Accounts                        $2,500
  Floating-rate      None
  Fixed-rate         $7,000                         MMDAs                               $6,000
Total                              $7,000
Consumer loans                     $5,000           Short-term                 $9,000
                                                    From 1 to 5 years          None
Mortgages                                           Total                               $9,000
  Floating-rate      None
  Fixed-rate         $2,000                         Federal funds                        $500
Total                              $2,000
                                                    Long-term bonds                      $400
  Short-term         None                           Capital                              $800
  Long-term          $1,000
  Total                            $1,000

  High-rated         None
  Moderate-rated     $2,000
  Total                            $2,000

  High-rated         None
  Moderate-rated     $1,700
  Total                            $1,700

Fixed Assets                         $500
208  Chapter 19/Bank Management

    TOTAL                                                      TOTAL LIABILITIES
    ASSETS                                   $20,000           AND CAPITAL                       $20,000

                                 Exhibit B: Industry Norms in Percentage Terms

                       Assets                                     Liabilities and Capital

 Required reserves                              4%             Demand Deposits                     17%
 Commercial loans                                              NOW Accounts                        10%
   Floating-rate                20%
   Fixed-rate                   11%                            MMDAs                               20%
   Total                                       31%
 Consumer loans                                20%               Short-term            35%
                                                                 From 1 to 5 years     10%
 Mortgages                                                       Total                             45%
   Floating-rate                7%
   Fixed-rate                   3%                             Long-term bonds                      2%
   Total                                       10%               Capital                            6%

 Treasury securities
   Short-term                   7%
   Long-term                    8%
   Total                                       15%

 Long-term corporate
   High-rated                   3%
   Moderate-rated               2%
   Total                                        5%

 Long-term municipal
   High-rated                   3%
   Moderate-rated               2%
   Total                                        5%

 Fixed Assets                                   5%                                           __________

                                                               TOTAL LIABILITIES
 TOTAL ASSETS                                 100%             AND CAPITAL                        100%
                                                                        Chapter 19/Bank Management  209

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 dependent on 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.

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