Money and Banking: Lecture 25

Money and
Banking

Lecture 25


Review of the Previous Lecture
• Balance Sheet of Commercial Banks
• Assets: Uses of Funds
• Liabilities: Sources of Funds
• Bank Capital and Profitability

• Off-Balance-Sheet Activities


Topics under Discussion
• Bank Risk
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•
•
•
•

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


Liquidity Risk


Liquidity Risk
•

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).


Liquidity Risk
•

Two other ways to manage liquidity risk
are:
•
•

adjusting assets
adjusting liabilities.


Liquidity Risk

• If a customer makes a $5 million withdrawal,
the bank cant simply deduct it from reserves.
• Rather it will adjust another part of balance
sheet


Liquidity Risk

• 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


Liquidity Risk


Liquidity Risk
• 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)


Liquidity Risk


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
• 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


Credit Risk
• 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;


Interest-Rate Risk
• 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)


Interest-Rate Risk
• 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

Interest-Rate Risk
• 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%



Interest-Rate Risk
• 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


Summary
• Bank Risk
• Liquidity Risk
• Credit Risk
• Interest Rate Risk