ECON7003 Money and Banking. Hugh Goodacre Topic 3. PRINCIPLES OF BANK MANAGEMENT

1. ECON7003 Money and Banking. Hugh GoodacreTopic 3.PRINCIPLES OF BANK MANAGEMENT • The bank’s balance sheet • Managing the bank’s balance sheet: • 1. Liquidity management. • 2. Asset management. • 3. Liability management. • 4. Capital adequacy management. • Off-balance-sheet activities.

2. The bank’s balance sheet • Four core / traditional principles of bank management: • Liquidity management. • Asset management. • Liability management (only to prominence since 1960s). • Capital adequacy management. • These four principles all concern management of the bank’s balance sheet. • This has two columns; Assets and Liabilities: • Liabilities – sources of the bank’s funds. Assets – uses to which the bank puts these funds.

3. Example of a bank’s balance sheet: Assets Liabilities TOTAL TOTAL

4. Reserves consist of: • ‘Vault Cash’ (UK: ‘Cash in Till). • Funds held by the bank in its account at the Central Bank • If a cheque for £100 is drawn upon Bank I and is paid by the recipient into Bank II, then Bank I owes Bank II £100. • This debt is paid through the clearing system at the Central Bank: • The CB withdraws £100 from the account of debtor bank (A) and pays it into the creditor bank (B). • There is thus a one-to-one relation between deposits and reserves.

5. Bank I Assets Liabilities Reserves Deposits Bank II Assets Liabilities Reserves Deposits ‘T-accounts’: These are simplified balance sheets listing only the changes that occur in balance sheet items starting from an initial balance sheet position.

6. Bank II Assets Liabilities Reserves Deposits Bank II has now gained £100 in reserves. Say it has a Required Reserve Ratio of 10%. It thus has an additional £ of Excess Reserves. Bank II Assets Liabilities Required Reserves Deposits Excess Reserves It can use these ER to invest in interest bearing assets (reserves earn no interest).

7. Bank profit: • Revenuefrom assets, e.g. • interest from loans, securities, etc. • less • Costsincurred on liabilities, e.g. • Costs of servicing a deposit account: • keeping records • sending statements • paying cashiers • maintaining buildings/branches • returning cancelled cheques • cheque clearing charges • advertising and marketing costs • interest paid to depositor (if interest-bearing account).

8. Recall: Bank II gained £90 of Excess Reserves as a result of A’s deposit. It now uses the addition to its ER to make a loan to B at 10%. Bank II Assets Liabilities Required Reserves Deposits from A Loan to B • It pays A 5% on his/her deposit. • An additional cost of 3% is incurred in servicing this account. • Its profit is thus: • Revenue on asset side: £9 • less • Costs incurred on liabilities side: £=

9. Return on Assets: Profit (i.e. revenue net of costs) as percentage of total assets. • When it first received A’s deposits the resulting return on its increase in assets was nil: • Reserves receive no interest → ROA = 0/100 = 0%. Bank II Assets Liabilities Required Reserves Deposits Excess Reserves • But once it had used the addition to its ER to make a loan to B, it made a profit of £ ( = Revenue £ m – Costs £ m). • → ROA = / = %.

10. Assets Liabilities Reserves Deposits Loans Securities TOTAL • Bank Capital. • The difference between a bank’s assets and liabilities. • → alternatively defined as ‘net worth’. • Included in the liabilities column of the balance sheet. Bank Capital TOTAL

11. Principal 1 Liquidity management. • Sustain adequate liquidity to meet deposit outflow Deposit outflow means equivalent loss of reserves → Liquidity management is equivalent to Reserve adequacy management. • Replenishing reserves • Original / ‘traditional’ means: • Adjust the balance sheet: • Borrow from other banks or firms, or Central Bank (discount loans). • Sell securities. Call in or sell off loans.

12. BUT: Rearranging balance sheet is costly: • Borrowings: Payment of interest. Sell securities: Loss of interest. Calling in loans: Loss of interest. BUT ALSO / most costly of all: Also damage to customer relationships. Probable ‘fire sale’ conditions → poor price: Loss of subjective / informational value. • ER thus traditionally a form of insurance / ‘cushion’ against these costs. In fact largely superseded in recent decades: Other forms of insurance -- hedging / derivatives, etc.

13. Note the very low ER of US banks since the early 1960s. • Note also inverse relationship to interest rate. • Dwindles almost to zero when r is high.

14. A bank’s Assets are: reserves £20m, loans £80m, securities £10m. Its Liabilities are £100m deposits. Its RRR is 10%. It now faces a deposit withdrawal of £10m. Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL

15. T-account after the deposit withdrawal: Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL • No action is needed to replenish reserves following this withdrawal: • RRR of 10% → only m reserves required. • There remain m ER.

16. Now suppose that before the deposit withdrawal the bank had made an additional loan of £10m: Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL

17. The bank now faces the deposit withdrawal of £10m: Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL • Action is needed to replenish reserves, which have fallen to . • £ reserves required.

18. Assets Liabilities Reserves Deposits Bank Capital Loans9 TOTAL Securities TOTAL Replenishing reserves (1) Borrow from banks, firms or CB: Borrowings • Cost: Interest paid. • In case of borrowings from CB, this is the ‘Discount Rate’. • Note: The bank’s BS has here ‘expanded’. • Before borrowing, it had been only 100m

19. Replenishing reserves (2) Sell securities. • → Securities fall from 10m to 1m: Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL • Cost (besides loss of interest): • Transaction costs (brokerage, etc.). • Can be very low in case of govt securities (Gilts, US TBs, etc.) • ‘Secondary reserves’.

20. Replenishing reserves (3) Call in loans. • → Loans fall from 90m to 81m: Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL • Cost: The costliest of all: • Damages customer relationships. • Selling loans on may be at unfavourable price: • Loss of informational element in their value. • Particularly if sold under ‘fire sale’ conditions.

21. Principle 2: Asset management. Assets vary in: liquidity riskiness nature of their return e.g. fixed interest payments or dividends. • Variation in liquidity → asset management is interconnected with liquidity management. • e.g. easily-traded securities like US Treasury Bonds, UK ‘Gilts’, etc., may serve as ‘secondary reserves’

22. A financial asset for one agent is by definition a liability for another. The bank’s reserves are no exception: They are a liability for the CB. Reserves thus appear in the CB’s liabilities column! (So does cash.) Other kinds of assets provide direct utility of various kinds. e.g. owner-occupied housing.

23. Note: An asset for one agent is a liability for another. Every category of economic agent has liabilities to, and assets with, banks: HH, FF, G; also other BB and CB.

25. Asset management must address issues of risk: • Notably credit risk. • Also interest-rate and exchange-rate risk. • Credit risk management: • Central issue is asymmetric information. • i.e. Borrower is better informed on own risk profile than bank.

26. Traditional strategies for countering credit risk : • Screening borrowers before issuing loan. To counter ‘adverse selection’. • Monitoring borrowers’ behaviourafter loan is issued To counter ‘moral hazard’. • Diversificationorspecialization. • Imposing restrictive conditions (‘covenants’) on borrowers’ use of the loan. • Requiring borrowers to supply collateral. • Credit rationing. BUT: Now largely credit swaps and other innovations.

27. Principle 3: Liability management. Traditional / original form of issue to non-equity-holders of liabilities was deposit creationfor customers. It is this aspect of bank management that has changed the most radically in recent decades.

28. Stylised pre-history of banking. • A gold dealer provides a service to customers: • Stores their gold coins in a safe house. • Issues deposit notes to them for the amount stored. • e.g. The owner takes in £100 in gold coins, shown as T-account: Safe house Assets Liabilities Gold coins Deposit notes • These deposit notes become accepted in transactions as a substitute for payment in gold • i.e. Gold (‘commodity money’) becomes ‘customary money’ – a financial instrument (‘bank note’).

29. A safe house owner storing £100 in gold coins now makes loans to the value of £900. Safe house Assets Liabilities Gold coins Deposit notes Loans issued i.e. The store house owner has now become an early ‘banker’, issuing credit.

30. Liquidity management: Decide gold:deposit-note ratio. • i.e. in this case 1:10 • Based on assessing trade-off between: • Profitability of loans • Liquidity • Insufficient liquidity to meet demands for withdrawals of gold coins → may be a ‘run’, or panic. • Note: Only liability here is deposit notes. • i.e. Liability management is identical with liquidity management.

31. ‘Traditionally’, items in theliabilities column were just: Customers’ deposits. Originally the only item, as seen in the case of the safe house owner. Borrowings. Commonly very small proportion. e.g. Only 2% in US in 1960. Bank capital. i.e. Once banks became companies > sole traders.

32. But now customers’ deposits → only a small proportion (e.g. 10%) of banks’ liabilities / sources of funds. • If bank sees loan opportunities → wants sources of funds, etc., actively procures liabilities in money markets: • ‘Non-transaction deposits’. • e.g. Certificates of Deposit (CDs).

33. Liabilities of all US commercial banks (%), December 2004. • Deposits from > 60% (1960s) to < 10%. • Borrowings from 2% in 1960s to 21%. • Non-transaction deposits: an innovation. • Only became possible through deregulation of recent decades.

34. Review of changes (see Topic 2): • Formerquantitative controls on banking → ‘traditional’ situation: • Liabilities side: Largely passive supply. • Customers’ deposits. • Assets side: Active adjustment of balances sheets. • Reserves as constraint on issue of liabilities. • Thus Liability Management has only become a distinct branch of bank management in recent decades.

35. We thus now have: Balance sheet of all US commercial banks (%), December 2004.

36. Principle 4: Capital adequacy management. • A bank’s assets are: £ 75m reserves • £400m loans • £125m securities • Liabilities: £500m deposits • Its required reserve ratio is 10%. Assets Liabilities Reserves Deposits Loans Securities Bank Capital TOTAL TOTAL

37. The bank now suffers a deposit outflow of £50m. • → Deposits are now 500-50 = 450 • → Reserves fall to 75-50 = 25 Assets Liabilities Reserves Deposits Loans Bank Capital Securities TOTAL TOTAL • Bank must now replenish its reserves by to sustain RRR. • Borrow from other banks or firms, or take discount loan from CB. • Sell securities. • Call in £ loans (high transaction costs and damage to customers relations).

38. Capital adequacy management: The ‘Low Capital Bank’. Capital:Asset ratio 4%. Assets Liabilities Reserves Deposits Loans Bank Capital TOTAL TOTAL

39. Capital adequacy management: The ‘Low Capital Bank’. • The bank is now hit by a slump in one of the industries where its loans have been concentrated, and has to write off £5m loans. • → Loans now Assets Liabilities Reserves Deposits Loans Bank Capital TOTAL TOTAL Bank is in big trouble: negative net worth / insolvent. Insufficient assets to pay off liabilities (creditors). Government regulators may close bank and sell off its assets.

40. Capital adequacy management: The ‘High Capital Bank’. Capital:Asset ratio 10%. Assets Liabilities Reserves Deposits Loans Bank Capital TOTAL TOTAL

41. Capital adequacy management: The ‘High Capital Bank’. • This bank is also now hit by a slump in one of the industries where its loans have been concentrated, and has to write off £5m loans. • → Loans now Assets Liabilities Reserves Deposits Loans Bank Capital TOTAL TOTAL Bank can take this loan write off in its stride. Initial ‘cushion’ of £10m means NV still positive. No need to replenish reserves –RRR = 10% → ER = £

42. Core / ‘traditional’ principles of bank management derive profit from asset transformation, i.e. • Draw in funds at lower cost on the liability side. • Put them to more profitable use on the asset side. • i.e. This bank profit is from items ‘on the balance sheet’.

43. Balance sheet of all US commercial banks (%), December 2004. Changes in banks’ balance sheets – review: Rise of liability management: Money markets / non-transactions deposits to acquire funds > customers’ deposits. Same for liquidity management > high excess reserves. Also: Interest rate risk: hedging instruments > adjustments to balance of interest-sensitive and interest-insensitive assets items on BS.

44. Off-balance-sheet activities. • Deregulation, etc., → banks now also → further activities: • Not defined with respect to BS • i.e. Not appearing on the balance sheet. • Merging of activities of banks and non-bank financial institutions (nbfis). • Boundaries less distinct.

45. Non-interest income as %age of gross income, UK large banks: Extent of Off-Balance-Sheet activity • Note: Actually now a declining proportion. • Due to increased competition from nbfis.

46. Examples of OBS activities. Fee income from specialized services, e.g. • Investment services, as seen. • Other investment bank services, e.g.issue of securities. • Foreign exchange trades for customers. • Fund management. • Credit cards.

47. Examples of OBS activities , contd. Trading activities and risk management on own behalf, e.g. • Foreign exchange dealings. • Dealing in derivatives: • Financial futures, interest rate and exchange rate hedging, etc. • Note: Original purpose of derivatives, etc.: • Mitigate risk. • But in fact → massive speculation, including by banks. • → whole new range of management problems.

48. 1. Liquidity management. • Meet demands for deposit withdrawals. • Equivalent to reserve adequacy management. • 2. Asset management. • Counter credit and other risk. • Problems of AI (AS and MH). • 3. Liability management. • Has changed radically in recent decades. • From ‘passive’ taking in of deposits. • To active sourcing of funds on money market. • 4: Capital adequacy management. • Sustain capital ‘cushion’. • Avoid negative equity / insolvency. • Off-Balance-sheet activities.