Assets, Liabilities, and Capital Management

1. Learning Unit #18
Assets, Liabilities, and
Capital Management

2. Objectives of Learning Unit
Since banks own and owe various types of
financial instruments, it is crucial to manage their
risk, liquidity, and return.
 Asset, liability, & capital management
 Liquidity management
 Default risk management
 Interest rate risk management

3. Asset, Liability, & Capital Management
 Different types of assets and liabilities have
different liquidity, return, and risk.
 There is a trade off between profits and
risk/liquidity on any financial instruments.
 A bank must manage its assets and liabilities to
earn profits as much as possible while keep its
risk low and liquidity high.

4. Asset, Liability, & Capital Management
and Stakeholders
 Should a bank try to make as much profits as possible?
 For any financial instrument, a saver can get a high return only if
he takes a high risk and low liquidity, so as banks.
 Should a bank take a high risk and low liquidity to achieve high
profit? Or, it take a very low risk and get low profits?
 High risk means that a bank may not get loaned money back
and incur losses.
 Low liquidity means that a bank may run out of cash on hand.
 Bank’s asset, liability & capital management affects both
depositors and shareholders of banks.
 Are depositors happy if their bank goes out of business because
it takes too much risk, or if their bank run out of cash when they
need to get cash?
 Are shareholders happy if their bank goes out of business, or if
their bank make too little profits?

5. Three Types of Asset, Liability, &
Capital Management
A bank must choose what kind of assets and
liabilities it holds and how much of them. Three
important considerations are their return, risk,
and liquidity. Here, we explore how a bank
manage its risk and liquidity and balance with its
return.
 Liquidity management
 Default (credit) risk management
 Interest rate risk management

6. Liquidity Management
 A bank must maintain its liquidity to meet the
bank’s obligations to depositors.
 Depositors may withdraw any amount of funds any
time and the bank must be ready.
 Deposit outflows: Decreases in deposits when
depositors make withdrawals or demand payment.
 A bank must acquire sufficiently liquid assets.
 Vault cash – ready to be dispensed
 Highly liquid securities (e.g. Treasury bills) – can
be sold immediately for cash.
 Loans, most profitable (high yield) assets for
banks, are not liquid at all.

7. Trade off between Liquidity and Profits
 Should a bank hold a lot of cash on hand and
loan very little deposited funds out?
 It will earn little profits, but can meet its obligation
to depositors always.
 Depositors are happy, but not shareholders.
 Or, should a bank hold very little cash and
loan most of deposited funds out?
 It will earn high profits, but may not be able to
meet its obligation to depositors sometime.
 Shareholders are happy, but not depositors.

8. Liquidity Management: Example
 Required reserves ratio is 10%.
 Initial balance sheet of BB&T.
 Required Reserves =$11M (10% of $110M deposits)
 Excess Reserves = $9M ($20M-$11M)
Reserves $20M
Loans $90M
Securities $10M
Deposits $110M
Capital $10M
BB&T

9. Liquidity Management: Deposit Outflow
 Mr. Gates withdraws $10M from BB&T.
 This transaction affects both reserves and deposits of
BB&T.
 T-account of this transaction:
Reserves -$10M Deposits -$10M
BB&T

10. Liquidity Management: Effect of Deposit
Outflow
 Balance sheet of BB&T after $10M withdrawal.
 Both reserves and deposits are $10 M less than the initial.
 As a result, BB&T’s required and excess reserves also
change.
 Required Reserves =$10M (= 10% of $100M deposits)
 Excess Reserves = $0M (= $10 Reserves - $10 Required
Reserves)
 Although BB&T does not have any more excess reserves, it met
Mr. Gate’s request and still meets its reserve requirement.
Reserves $10M
Loans $90M
Securities $10M
Deposits $100M
Capital $10M
BB&T

11. Liquidity Management: Deposit Outflow
When Bank Hold No Excess Reserves
 Mr. Jobs withdraws $10M from BB&T after Mr. Gates.
 T-account of this transaction:
 Resulting balance sheet of BB&T:
 Does BB&T have enough reserves to meet its
requirement?
Reserves -$10M Deposits -$10M
BB&T
Reserves $0M
Loans $90M
Securities $10M
Deposits $90M
Capital $10M
BB&T

12. Liquidity Management: Effect of Deposit Outflow
When Bank Hold No Excess Reserves
 Required Reserves =$9 M (10% of $90M deposits).
 With $0 of reserves, BB&T does not meet its legal
requirement of reserves.
 The Fed can close BB&T if it does not meet its
requirement,
 BB&T must come up to $9 M of reserves.
 When a bank does not have excess reserves (or not
enough excess reserves), after deposit outflows the
bank will be short of reserves and must take some
actions to obtain enough reserves to meet its
requirement.

13. Three Actions to Increase Reserves
A bank can take one of following actions to raise
its reserves.
 Call loans
 Sell securities
 Borrow from the Fed or other banks
 Getting more deposits will increase its reserves, but
there is no control of deposits inflows by the bank (so a
bank should not count on).

14. Call Loans
 Call Loans: A bank calls one of its customers and
ask to pay back his loan earlier (before its due).
 Example: Call Mr. Edwards to pay back $9 M
loans now. When Mr. Edwards pays back to
BB&T in cash,
 Mr. Edwards no longer owes to BB&T, so BB&T’s loan
decreases by $9 M.
 BB&T has extra $9 M of reserves (cash).
 T-accounts of this transaction:
Reserves +$9M
Loans -$9M
BB&T

15. Effect of Calling Loans
 Once a loan is paid off, BB&T’s balance sheet
should be
Reserves $9M
Loans $81M
Securities $10M
Deposits $90M
Capital $10M
BB&T
 How much are required reserves?
 Does BB&T have enough reserves?

16. Sell Securities
 Sell securities: A bank sells its inventory of
securities in market at a market price.
 Example: BB&T sells $9 M of Treasury bills.
 When BB&T sells $9 M of Treasury bills to
Citibank,
 BB&T’s security holdings decreases by $9 M.
 BB&T has extra $9 M of reserves (Fed’s account).
 T-accounts of this transaction:
Reserves +$9M
Securities -$9M
BB&T

17. Effect of Selling Securities
 Once securities are sold, BB&T’s balance sheet
should be
Reserves $9M
Loans $90M
Securities $1M
Deposits $90M
Capital $10M
BB&T
 How much are required
reserves?
 Does BB&T have enough
reserves?

18. Borrow from the Fed or other Bank
 Borrowings: A bank may borrow funds from the
Fed (discount loan), other bank (federal funds),
or corporations (e.g. repos).
 Example: Borrow $9M of discount loan from the
Fed.
 BB&T owes $9 M to the Fed (in borrowings).
 BB&T has extra $9 M of reserves (Fed’s account).
 T-accounts of this transaction:
Reserves +$9M Borrowings +$9M
BB&T

19. Effect of Borrowing from the Fed
 Once BB&T borrows from the Fed, BB&T’s
balance sheet should be
 How much are required reserves? Does BB&T
have enough reserves?
Reserves $9M
Loans $90M
Securities $10M
Deposits $90M
Borrowings $9M
Capital $10M
BB&T

20. Costs of Actions to Raise Reserves
 Although a bank may be able to obtain necessary
funds through calling loans, selling securities, or
borrowing from the Fed or other bank, these
actions are costly for the bank.
 When a bank calls loans, it may jeopardize its
customer relations (goodwill) and lower its
revenue.
 Do you like your bank to call you every day and to ask
you to pay back your student loan early? A bank which
frequently call loans may lose its customers over time
and lower its revenue.
 Bank may give a financial incentive to borrowers to pay
back early (e.g. lower final payment or low interest rates
on next loans).

21. More Costs of Actions to Raise Reserves
 When a bank sells its inventory of securities, it
may not be the right price.
 The bank may earn higher returns on securities if it
holds them until their maturities.
 When a bank borrows funds from the Fed, other
bank, or corporation, it must pay interest on
borrowed funds.
 These interest rates are high relative to that of deposits.
 The Fed will not be happy if a bank frequently borrows
funds to meet its requirement. Eventually, the bank is
not welcome to borrow.

22. Benefits and Costs of Excess Reserves
 Benefits of excess reserves:
 If a bank has ample reserves, the bank can still meet
the reserve requirement after deposit outflows and
will not need to take costly transactions to increase
reserves.
 Excess reserves are insurance against the costs
associated with deposit outflows.
 Costs of excess reserves:
 Excess reserves do not earn revenues, but still cost
banks since it must pay interests on deposits.
 More excess reserves, less loans the bank makes.
Excess reserves mean lost opportunities to earn more
revenues (and profits) from loans that could be made
if no excess reserves.

23. Liquidity Management
 A bank must maintain sufficient amount of
excess reserves (highly liquid assets) to
meet deposit outflows and still meet the
reserve requirement in order to avoid costs
associated with actions to increase reserves.
 The higher the costs associated with deposit
outflows, the more excess reserves banks will
hold.
 The more likely depositors withdraw from the
banks, the more excess reserves banks should
hold.

24. Default (Credit) Risk Management
 Like any financial instruments, loans are risky
and possibly default.
 A bank must hold sufficient amount of
capital to lessen the chance of becoming
insolvent in case of default of its assets.
 Insolvency: The value of assets falls below its
liabilities.
 Bankruptcy: A bank cannot meet its obligation to
pay its depositors and creditors.

25. Bankruptcy vs. Insolvency
 Any business firms or individuals can be insolvent
any time, but are not necessarily bankruptcy.
 How much assets do you have? How much liabilities
do you have? Are you insolvent?
 Even insolvent, they can continue businesses as long
as they pay their due on time.
 When business firms or individuals cannot meet
their obligations, they default and declare
bankruptcy.
 If you borrow too much and there is no way you can
pay back because your monthly income is less than
monthly payment on loans and you do not have any
valuable assets, what should you do?

26. Default Risk Management: Example
 Required reserve ratio is 10%.
 Initial balance sheet of First Home federal Bank:
 Is FHF solvent or insolvent?
 Total assets are $130 M.
 Total liabilities are $100 M (Capital is not a liability!).
 So, FHF is solvent!
Reserves $10M
Loans $90M
Securities $30M
Deposits $100M
Capital $30M
FHF

27. Default Risk Management: Default and
Accounting Transactions
 A borrower defaults $20M loan from FHF.
 $20 M loan will no longer be paid back.
 FHF must reduce its loans by $20 M on its balance sheet since it
is no longer note “receivable”.
 $20 M loan will not be back, that means, FHF lost it permanently.
It must report this loss on its income statement.
 When a firm makes profits, any profits not distributed as
dividends are added to “Retained earnings,” a part of owners’
equity. Conversely, if a bank makes losses, any losses must be
reflected in capital (owners’ equity) by subtracting loss amount
(defaulted loan value) from its capital (retained earnings).
 Writing off: this process of reducing loan amount on book
and realizing loss to reflect a loan default on accounting
book.

28. Default Risk Management: Effect of Default
 T-account of $20M loan write-off:
 Resulting balance sheet of FHF:
 Is FHF solvent or insolvent? With $110M total assets
and $100M total liabilities, FHF is still solvent.
Loans -$20M Capital -$20M
FHF
Reserves $10M
Loans $70M
Securities $30M
Deposits $100M
Capital $10M
FHF

29. Default Risk Management: Large Default
 Instead of $20 M of loan, $40M of loan from FHF is
defaulted. Then, T-account should look as
 Resulting balance sheet of FHF:
Loans -$40M Capital -$40M
FHF
Reserves $10M
Loans $50M
Securities $30M
Deposits $100M
Capital -$10M
FHF

30. Default Risk Management: Effect of Large
Default
 Now, total assets of FHF are $90M, while total liabilities of
FHF are $100 M.
 FHF is insolvent!
 Because FHF did not have large enough capital to write off a large
defaulted loan, it becomes insolvent.
 Although FHF is insolvent, it can still run its banking
business as usual.
 FHF needs to make profits over time to make up this loss and
eventually will have enough assets to pay back all liabilities.
 If depositors decide to withdraw all deposits from FHF,
then FHF will not have enough assets to meet its
obligation (Bank failure).
 FHF must declare bankruptcy! E.g. IndyMac Bank of CA in 2008.
 How to prevent depositors to withdraw funds out of FHF (so FHF
can avoid bankruptcy)?

31. Capital Adequacy Management and Default
Risk Management
 A bank must hold adequate amount of capital in
case of loan default and avoid insolvency.
 A bank can raise its capital by issuing more stocks.
 A bank can increase its capital by retaining its profits
rather than distributing them as dividends.
 The government must set some mechanism to
discourage depositors from withdrawing funds
from insolvent banks.
 FDIC [Learning Unit 20]
 A bank must reduce default risk on loans.

32. Bank Capital Requirement
 Bank failure is costly to shareholders, FDIC
(even government in case of S&Ls), community
(limit availability of loans), and the whole
economy.
 Bank capital requirement: the government sets
minimum amount of capital that each bank must
hold, based on amount of its assets and their
risk.
 Basel Accord: International standardized risk-based
capital requirement [Learning Unit 20]

33. Managing Default (Credit) Risk
A bank can reduce risk on loans through
 Screening and monitoring
 Long-term customer relationship
 Loan commitments: Bank’s commitment to provide a
firm with loans up to a given amount (line of credit).
 Collateral and compensating balance: A firm receiving
a loan must keep a required minimum amount of
funds at the bank.
 Credit rationing: Refusing to make loans
All of these actions reduce the problems of adverse
selection and moral hazard arisen from asymmetric
information, faced by banks.

34. Screening & Monitoring
 Adverse selection in loan requires that lenders
screen out the bad credit risks from the good
ones.
 If someone wants to borrow your money, what
do you do first (beside say no)?
 Effective screening and information collection
are two important parts of default risk
management. They are achieved through
 Loan application (information collection)
 Background check (information verification)
 Credit score (risk assessment)

35. Screening & Monitoring
 Specialization in Lending: A bank may specialize
in lending to local firms or to firms in particular
industries, because it is easier to collect
information and to develop expertise.
 Ex. Mortgage loans to households who purchase
houses locally
 Monitoring and Enforcement of Restrictive
Covenants: A bank must monitor borrowers to
adhere the restrictive covenants (what borrowers
can do and not to do) on loan contracts in order
to prevent or minimize costs of moral hazard.
 Ex. Foreclosure of house if not paid on time

36. Long-term Customer Relationship
 Bank accumulates information of borrowers
through its long-term customer relationships.
 Detail financial information of potential borrowers
 Behavior information of potential borrowers (Big
spender? Gambler?)
 These information helps bank to make better decision
by reducing asymmetric information.
 Your bank knows a lot of your finance:
 How much you earn each month.
 Where you work (if your salary is directly deposited at
your bank).
 How you spend your money.

37. Loan Commitments
 Loan commitment: A bank’s commitment to
provide a customer with loans up to a given
amount at an interest rate that is tied to some
market interest rate.
 Business loans: a bank pre-approve a loan up to
certain amount and a firm can get it any time.
 Home equity line of credit: use real estate as collateral,
a household can borrow up to a pre-approved amount.
 Credit card: you can borrow up to credit limit and its
interest rate is determined by xx% above the prime
rate.
 Loan commitments promote a long-term
relationship with customers and facilitate
information collection.

38. Collateral and Compensating Balance
 Collateral: property that is pledged to the lender to
guarantee payment in the event that the borrower is unable
to make debt payments.
 If you get an auto-loan when you purchase your car, your car is
most likely a collateral for the auto-loan.
 All mortgage loans require real estates (land and house) as
collateral.
 Collateral not only reduce loss in event of default, but also reduce
moral hazard (borrowers are more likely to pay back their loans in
order to keep their properties).
 Compensating balance: when a bank makes a loan to its
customer, it requires the customer to maintain minimum
balance in its account.
 It is one type of collateral, because the bank can seize it if the
borrower defaults.

39. Credit Rationing
 Credit rationing: a bank refuses to make or
extend loans to borrowers, who are willing to pay
the stated interest rate or even a higher rate.
 A bank refuses to make loans of any amount to
potential borrowers as a way of weeding risky
borrowers with adverse selection.
 A bank restricts the size of the loan to less than the
borrower would like in order to minimize the moral
hazard problem.

40. Interest Rate Risk of Bank
 Interest rate risk: A price of security may change
and its total rate of return when the market
interest rate changes. [Learning Unit #10]
 Since a bank holds a variety of financial
instruments with different maturities, any
changes in market interest rates have an effect
on bank’s financial condition.
Most of bank’s assets and liabilities are
financial instruments with maturity!

41. Measuring Interest Rate Risk of Bank
 A change in market interest rate affects
 Bank’s revenue and cost: Interest rates on some
assets and liabilities may change as market interest
rate changes, affecting its revenue and cost.
 Value of bank’s assets and liabilities: Depending on
maturity, value of assets and liabilities change as
market interest rates change.
 Two methods to measure bank’s exposure to
interest rate risk:
 Gap analysis to measure its effect on bank’s profits
 Duration analysis to measure its effect on values of
bank’s assets and liabilities

42. Gap Analysis
 Gap analysis measures the sensitivity of bank
profits to changes in market interest rates.
Gap = the amount of rate-sensitive assets minus
the amount of rate-sensitive liabilities.
∆Profit = Gap x ∆i
where
∆Profit is a change in bank’s profits
∆i is a change in market interest rate

43. Rate Sensitive and Fixed Rate Assets and
Liabilities
 Rate sensitive assets and liabilities are those financial
instruments whose interest rates change as a market
interest rate changes.
 Examples of rate sensitive assets: Adjustable rate mortgage
loans, credit card loans
 Examples of rate sensitive liabilities: money market accounts,
checkable deposits (with variable rate)
 Fixed rate assets and liabilities are those financial
instruments whose interest rates do not change when a
market interest rate changes.
 Examples of fixed rate assets: Fixed rate mortgage loans, auto-
loans, student loans, Treasury securities, Reserves (0% always)
 Examples of fixed rate liabilities: CDs, checkable deposits (with
no interest)

44. Gap Analysis: Example
 A bank has the following rate-sensitive and fixed-
rate assets and liabilities:
 The Gap of the bank is -$300M = $200M of rate
sensitive assets - $500M of rate sensitive
liabilities.
 If the market interest rates increase by 5%, then
its profits will decrease by $15M.
∆Profit = -$300M x 5% = -$15M
Rate-sensitive $200M
Fixed-rate $800M
Rate-sensitive $500M
Fixed-rate $500M

45. Duration Analysis
 Duration analysis measures the sensitivity of
market values of total assets, liabilities, and
net worth to changes in market interest rates.
%∆(Market value of asset) = -%∆i x (Duration of asset)
where
%∆(Market value of asset) is a percentage change
in market value of assets,
%∆i is a percentage change in interest rate

46. Duration
 Duration: a weighted average number of years of
cashflows from a financial instrument.
 Weights are present values of cashflows.
 If all cashflows come at its maturity like zero-coupon
bonds, then its duration will be the same as its maturity.
 A zero-coupon bond with 10 year maturity has 10
year of duration.
 If some cashflows come before its maturity like coupon
bonds, then its duration will be less than its maturity.
 If one instrument pays out $500 one year later and
another $500 two years later, then the duration is
about 1.5 years.

47. Duration Analysis: Example
 A bank has the following balance sheet:
where
Duration of total assets = 5 years
Duration of total liabilities = 3 years
 Note: In this class a duration information is given.
Total assets $200M Total Liab. $180M
Capital $20M
Book Value

48. Duration Analysis: Example
 If the market interest rates increase by 5%, then
%∆(Market value of total assets) = - 5% (of interest rate
increase) x 5 (years of duration)
= -25%
%∆(Market value of total liab.) = - 5% (of interest rate
increase) x 3 (years of duration)
= -15%
Note:
There is a minus sign in front of interest rate change in the
formula.
A percentage change in value of total liabilities is computed in the
same manner as a percentage change in value of total assets.
The formula is not applied to compute a percentage change in
value of capital!

49. Market Values of Balance Sheet
 Although a change in market interest rates does
not affect the book values of assets and
liabilities, their market values are affected.
 Book values of assets and liabilities are historical
costs of those assets and liabilities, so they do not
change.
 When a bank has to sell its assets, it may not be able
to sell them at their book value, but at on-going
market prices.
 Duration analysis measures market values of
bank’s assets and liabilities, not book values.
 It tells how much actually banks can get if it liquidates
all assets and liabilities today.

50. Market Values of Total Assets and Total
Liabilities: Example
 Duration analysis indicates that a market value
of total assets is 25% less than the book value
of total assets.
Market value of total assets = $200M (of book
value of total assets) – 25% x $200M
= $150M
 A market value of total liabilities is 15% less than
the book value of total liabilities.
Market value of total liabilities = $180M (of book
value of total liabilities) – 15% x $180M
= $153M

51. Net Worth
 Net worth: Market value of capital
Net worth = Market value of total assets minus
Market value of total liabilities
Net worth = $150M (of total assets) - $153M (of total
liabilities)
= -$3M
 Market value of the balance sheet:
Total assets $150M Total Liab. $153M
Capital -$3M
Market Value

52. Interest Rate Risk of Bank
 Most banks have a negative gap because they
tend to have large amount of fixed-rate assets
(e.g. securities, most loans, reserves).
 When the market interest rates increase, most
banks experience a fall of their profits, or even
losses.
 All banks have longer duration on their assets
than their liabilities because they provide asset
transformation services to make profits.
 When the market interest rates increase, net
worth of all banks decreases or even becomes
negative (insolvency!).

53. Interest Rate Risk Management
 Banks can reduce their exposure to the interest
rate risk by
Increasing gap
Reducing duration of assets and increasing
duration of liabilities

54. Interest Rate Risk Management: Increasing
Gap
 Banks increase their gaps by
 Obtaining more rate-sensitive assets
 Make more adjustable-rate mortgage loans and
credit card loans
 Holding less fixed-rate assets
 Sell fixed-rate loans (loan sales of off-balance
sheet activity)
 Issuing more fixed-rate liabilities
 Issue more fixed-rate CDs
 Engaging in derivative trading
 Swap fixed-rate assets with variable-rate assets
 Issue futures or purchase call options

55. Interest Rate Risk Management: Changing
Durations
 Reducing duration of assets by
 Making more short-term loans
 Purchasing more short-term securities
 Increasing duration of liabilities by
 Issuing more long-term CDs
 Issuing long-term bonds
 These actions to affect durations of assets and
liabilities may reduce bank’s revenues and
increases bank’s costs, resulting in lower profits.
 Like liquidity management and default risk
management, there is a trade-off between safety and
profits.

56. Assets, Liabilities, and Capital Management
and Bank’s Profits
 Banks can reduce their default (credit) risk and
interest rate risk and increase their liquidity by
obtaining particular assets or liabilities.
 Banks’ actions to reduce risk and increase
liquidity tend to reduce their profits.
 Assets, liabilities, and capital management must
balance between risk and profits.
 Some banks are more on safe side with low profits.
 Other banks aim for high profits with high risk.
 Their choices are affected by shareholders of banks,
depositors of banks, creditors of banks, CEO of
banks, and government regulators.

57. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University