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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 25
BANK RISK
Bank Risk
Liquidity Risk
Credit Risk
Interest Rate Risk
Trading Risk
Other Risks
Bank Risk
Banking is risky because depository institutions are highly leveraged and because what they do
In all the lines of banking trades, the goal of every bank is to pay less for the deposits the bank
receives than for the loan it makes and the securities it buys.
Liquidity Risk
Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a
bank's balance sheet (deposit withdrawal on one side and the funds needed for its off-balance
sheet activities on the liabilities side
If a bank cannot meet customers' requests for immediate funds it runs the risk of failure; even
with a positive net worth, illiquidity can drive it out of business
Table: Balance sheet of a bank holding $5 million in excess reserves
Assets
Liabilities
Reserves
$15million
Deposits
$100million
Loans
$100million
Borrowed funds
$30million
Securities
$35million
Bank capital
$20million
One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required
reserves mandated by the central bank) to accommodate customers' withdrawals.
However, this is expensive (interest is foregone)
Two other ways to manage liquidity risk are:
Adjusting assets
Adjusting liabilities
Table: Balance sheet of a bank holding no excess reserves
Assets
Liabilities
Reserves
$10million
Deposits
$100 million
Loans
$100 million
Borrowed funds
$30 million
Securities
$40 million
Bank capital
$20 million
If a customer makes a $5 million withdrawal, the bank can't simply deduct it from reserves.
Rather it will adjust another part of balance sheet
A bank can adjust its assets by
Selling a portion of its securities portfolio,
Or by selling some of its loans,
Or by refusing to renew a customer loan that has come due
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Money & Banking ­ MGT411
VU
Table: Balance sheet of a bank following a $5 million withdrawal and asset adjustment
Withdrawal is met by selling securities
Assets
Liabilities
Reserves
$10million
Deposits
$95 million
Loans
$100 million
Borrowed funds
$30 million
Securities
$35 million
Bank capital
$20 million
Withdrawal is met by reducing loans
Assets
liabilities
Reserves
$10 million
Deposits
$95 million
Loans
$95 million
Borrowed funds
$30 million
Securities
$40 million
Bank capital
$20 million
Banks do not like to meet their deposit outflows by contracting the asset side of the balance
sheet because doing so shrinks the size of the bank
Banks can use liability management to obtain additional funds by
Borrowing (from the central bank or from another bank) or
By attracting additional deposits (by issuing large CDs)
Table: Balance sheet of a bank following a $5 million withdrawal and liability adjustment
Withdrawal is met by borrowing
Assets
Liabilities
Reserves
$10million
Deposits
$95 million
Loans
$100 million
Borrowed funds
$35 million
Securities
$40 million
Bank capital
$20 million
Withdrawal is met by attracting deposits
Assets
liabilities
Reserves
$10 million
Deposits
$100 million
Loans
$100million
Borrowed funds
$30 million
Securities
$40 million
Bank capital
$20 million
Credit Risk
This is the risk that loans will not be repaid and it can be managed through diversification and
credit-risk analysis
Diversification can be difficult for banks, especially those that focus on certain kinds of lending
Credit-risk analysis produces information that is very similar to the bond-rating systems and is
done using a combination of statistical models and information specific to the loan applicant
Lending is plagued by adverse selection and moral hazard, and financial institutions use a
variety of methods to mitigate these problems
Screen loan application
Monitor borrowers after they have received loan
Collateral or high net-worth demand
Developing long term relationships
Interest-Rate Risk
The two sides of a bank's balance sheet often do not match up because liabilities tend to be
short-term while assets tend to be long-term; this creates interest-rate risk
In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet
(assets and liabilities) is to a change in interest rates;
If we think of bank's assets and liabilities as bonds, the change in interest rate will affect the
value of these bonds, more importantly due to the term of bonds
So if interest rate rises, the bank face the risk that the value of their assets may fall more than
the value of their liabilities (reducing the bank's capital)
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Money & Banking ­ MGT411
VU
Suppose 20% of bank's assets fall into the category of assets sensitive to changes in the interest
rate. While rest of 80%are not sensitive to changes in interest rate
If interest rate is stable 5%, then each $100 yields $5 in interest
Now suppose 50% of bank's deposits (liabilities) are interest rate sensitive and 50% are not
Half of the liabilities are deposits that earn variable returns so costs vary with market rate
For making profit, interest rate on liabilities must be lower than the interest rate on assets.
The difference is the bank's margin!
Assuming interest rate on liabilities is 3%, the net interest margin is 5 ­ 3 = 2%
What happens as interest rate rises by 1%
Table: An example of interest rate risk
The impact of an interest rate increase on bank profits (per $100 of assets)
Items
Assets
Liabilities
Interest rate sensitive
$20
$50
Not interest rate sensitive
$80
$50
Initial interest rate
5%
3%
New interest rate on interest rate
6%
4%
sensitive assets and liabilities
Revenue from assets
Cost of liabilities
At initial interest rate
(0.05$20)+(0.05$80)=$5.00
(0.03$50)+(0.03$50)=$3.00
After interest rate change
(0.06$20)+(0.05$80)=$5.20
(0.04$50)+(0.03$50)=$3.50
Profits at initial interest rate:
($5.00) ­ ($3.00) = $2.00 per $100 in assets
Profits after interest rate change:  ($5.20) ­ ($3.50) = $1.70 per $100 in assets
Gap analysis
Gap between interest rate sensitive assets and interest rate sensitive liabilities:
(Interest rate sensitive assets of $20) ­ (Interest rate sensitive liabilities of $50)
=(Gap of -$30)
When bank has more interest rate sensitive liabilities than does interest rate assets, an increase
in interest rate will cut into the bank's profits.
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY