Chapter 19 Bank Management Questions 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. 201 202 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 = Assets 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 maturities. 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 borrower. 17. Bank Dividend Policy. Why might a bank retain some excess earnings rather than distribute them as dividends? 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. Problems 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? ANSWER: Interest revenues – Interest expenses Net interest margin = Assets $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? ANSWER: 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 ANSWER: net profit after tax ROE = equity $75,000,000 $600,000,000 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. ANSWER: 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 reserves Commercial NOW Accounts $2,500 loans Floating-rate None Fixed-rate $7,000 MMDAs $6,000 Total $7,000 CDs 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 Treasury securities Short-term None Capital $800 Long-term $1,000 Total $1,000 Long-term corporate securities High-rated None Moderate-rated $2,000 Total $2,000 Long-term municipal securities 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% CDs 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 securities High-rated 3% Moderate-rated 2% Total 5% Long-term municipal securities 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.