9.3 Bank Management Principles

Bankers must manage their assets and liabilities to ensure three conditions:

1. Their bank has enough reserves on hand to pay for any deposit outflows (net decreases in deposits) but not so many as to render the bank unprofitable. This tricky trade-off is called liquidity managementEnsuring that the bank has just the right amount of reserves—not too little, which would endanger the bank’s solvency, nor too much, which would decrease its profitability..
2. Their bank earns profits. To do so, the bank must own a diverse portfolio of remunerative assets. This is known as asset managementEnsuring that the bank’s assets have the right combination of liquidity, safety, and return.. It must also obtain its funds as cheaply as possible, which is known as liability managementAttracting enough deposits or borrowing enough to ensure that the bank can make the loans or purchase the assets it wants..
3. Their bank has sufficient net worth or equity capital to maintain a cushion against bankruptcy or regulatory attention but not so much that the bank is unprofitable. This second tricky trade-off is called capital adequacy managementEnsuring that the bank has enough capital, equity, or net worth to remain in operation while maintaining bank profitability as measured by return on equity (ROE)..

In their quest to earn profits and manage liquidity and capital, banks face two major risks: credit risk, the risk of borrowers defaulting on the loans and securities it owns, and interest rate risk, the risk that interest rate changes will decrease the returns on its assets and/or increase the cost of its liabilities. The financial panic of 2008 reminded bankers that they also can face liability and capital adequacy risks if financial markets become less liquid or seize up completely (trading is greatly reduced or completely stops; q* approaches 0).

Let’s turn first to liquidity management. Big Apple Bank has the following balance sheet:

Suppose the bank then experiences a net transaction deposit outflow of $5 million. The bank’s balance sheet (we could also use T-accounts here but we won’t) is now like this:

The bank’s reserve ratio (reserves/transaction deposits) has dropped from 10/30 = .3334 to 5/25 = .2000. That’s still pretty good. But if another $5 million flows out of the bank on net (maybe $10 million is deposited but $15 million is withdrawn), the balance sheet will look like this:

The bank’s reserve ratio now drops to 0/20 = .0000. That’s bound to be below the reserve ratio required by regulators and in any event is very dangerous for the bank. What to do? To manage this liquidity problem, bankers will increase reserves by the least expensive means at their disposal. That almost certainly will not entail selling off real estate or calling in or selling loans. Real estate takes a long time to sell, but, more importantly, the bank needs it to conduct business! Calling in loans (not renewing them as they come due and literally calling in any that happen to have a call feature) will likely antagonize borrowers. (Loans can also be sold to other lenders, but they may not pay much for them because adverse selection is high. Banks that sell loans have an incentive to sell off the ones to the worst borrowers. If a bank reduces that risk by promising to buy back any loans that default, that bank risks losing the borrower’s future business.) The bank might be willing to sell its securities, which are also called secondary reserves for a reason. If the bankers decide that is the best path, the balance sheet will look like this:

The reserve ratio is now .5000, which is high but prudent if the bank’s managers believe that more net deposit outflows are likely. Excess reserves are insurance against further outflows, but keeping them is costly because the bank is no longer earning interest on the $10 million of securities it sold. Of course, the bank could sell just, say, $2, $3, or $4 million of securities if it thought the net deposit outflow was likely to stop.

The bankers might also decide to try to lure depositors back by offering a higher rate of interest, lower fees, and/or better service. That might take some time, though, so in the meantime they might decide to borrow $5 million from the Fed or from other banks in the federal funds market. In that case, the bank’s balance sheet would change to the following:

Notice how changes in liabilities drive the bank’s size, which shrank from $100 to $90 million when deposits shrank, which stayed the same size when assets were manipulated, but which grew when $5 million was borrowed. That is why a bank’s liabilities are sometimes called its “sources of funds.”

Now try your hand at liquidity management in the exercises.

Asset management entails the usual trade-off between risk and return. Bankers want to make safe, high-interest rate loans but, of course, few of those are to be found. So they must choose between giving up some interest or suffering higher default rates. Bankers must also be careful to diversify, to make loans to a variety of different types of borrowers, preferably in different geographic regions. That is because sometimes entire sectors or regions go bust and the bank will too if most of its loans were made in a depressed region or to the struggling group. Finally, bankers must bear in mind that they need some secondary reserves, some assets that can be quickly and cheaply sold to bolster reserves if need be.

Today, bankers’ decisions about how many excess and secondary reserves to hold is partly a function of their ability to manage their liabilities. Historically, bankers did not try to manage their liabilities. They took deposit levels as given and worked from there. Since the 1960s, however, banks, especially big ones in New York, Chicago, and San Francisco (the so-called money centers), began to actively manage their liabilities by

1. actively trying to attract deposits;
2. selling large denomination NCDs to institutional investors;
3. borrowing from other banks in the overnight federal funds market.

Recent regulatory reforms have made it easier for banks to actively manage their liabilities. In typical times today, if a bank has a profitable loan opportunity, it will not hesitate to raise the funds by borrowing from another bank, attracting deposits with higher interest rates, or selling an NCD.

That leaves us with capital adequacy management. Like reserves, banks would hold capital without regulatory prodding because equity or net worth buffers banks (and other companies) from temporary losses, downturns, and setbacks. However, like reserves, capital is costly. The more there is of it, holding profits constant, the less each dollar of it earns. So capital, like reserves, is now subject to minimums called capital requirements.

Consider the balance sheet of Safety Bank:

If $5 billion of its loans went bad and had to be completely written off, Safety Bank would still be in operation:

Now, consider Shaky Bank:

If $5 billion of its loans go bad, so too does Shaky.

You don’t need to be a certified public accountant (CPA) to know that red numbers and negative signs are not good news. Shaky Bank is a now a new kind of bank, bankrupt.

Why would a banker manage capital like Shaky Bank instead of like Safety Bank? In a word, profitability. There are two major ways of measuring profitability: return on assets (ROA) and return on equity (ROE).

ROA = net after-tax profit/assets

ROE = net after-tax profit/equity (capital, net worth)

Suppose that, before the loan debacle, both Safety and Shaky Bank had $10 billion in profits. The ROA of both would be 10/100 = .10. But Shaky Bank’s ROE, what shareholders care about most, would leave Safety Bank in the dust because Shaky Bank is more highly leveraged (more assets per dollar of equity).

Shaky Bank ROE = 10/1 = 10

Safety Bank ROE = 10/10 = 1

This, of course, is nothing more than the standard risk-return trade-off applied to banking. Regulators in many countries have therefore found it prudent to mandate capital adequacy standards to ensure that some bankers are not taking on high levels of risk in the pursuit of high profits.

Bankers manage bank capital in several ways:

1. By buying (selling) their own bank’s stock in the open market. That reduces (increases) the number of shares outstanding, raising (decreasing) capital and ROE, ceteris paribus
2. By paying (withholding) dividends, which decreases (increases) capital, increasing (decreasing) ROE, all else equal
3. By increasing (decreasing) the bank’s assets, which, with capital held constant, increases (decreases) ROE

These same concepts and principles—asset, liability, capital, and liquidity management, and capital-liquidity and capital-profitability trade-offs—apply to other types of financial intermediaries as well, though the details, of course, differ.