Module 5.3

Question 1

Bank Goals, Strategy, and Governance (1 of 4)

Answer 1

Aligning Managerial Compensation with Bank Goals Banks may implement compensation programs that provide bonuses to managers that satisfy bank goals. Bank Strategy  A bank’s decisions on sources of funds will heavily influence its interest expenses on the income statement.  A bank’s asset structure will strongly influence its interest revenue on the income statement.  How Financial Markets Facilitate the Bank’s Strategy To implement their strategy, commercial banks rely heavily on financial markets. (Exhibit

Question 2

Participation of Commercial Banks in
Financial Markets

Answer 2

Question 3

Bank Governance by the Board of Directors

Answer 3

Some of the more important functions of bank directors are to:

Determine a compensation system for the bank’s executives.

Ensure proper disclosure of the bank’s financial condition and performance to
investors.

Oversee growth strategies such as acquisitions.

Oversee policies for changing the capital structure, including decisions to raise
capital or to engage in stock repurchases.

Assess the bank’s performance and ensure that corrective action is taken if the
performance is weak because of poor management.

Question 4

Inside versus Outside Directors

Answer 4

Board members who are also managers of the bank (i.e. inside directors ) may
sometimes face a conflict of interests because their decisions as board members
may affect their jobs as managers.

Outside directors (directors who are not managers) are generally expected to be
more effective at overseeing a bank: They do not face a conflict of interests in
serving shareholders.

Question 5

Other Forms of Bank Governance

Answer 5

Publicly traded banks are subject to potential shareholder activism.

The market for corporate control serves as a form of governance because
bank managers recognize that they could lose their jobs if their bank is
acquired.

Question 6

Managing Liquidity

Answer 6

Banks can experience illiquidity when cash outflows (due to deposit
withdrawals, loans, etc.) exceed cash inflows (new deposits, loan
repayments, etc.).
Management of Liabilities

They can resolve cash deficiencies by creating additional liabilities or by
selling assets.

Some assets are more marketable than others, so a bank’s asset composition
can affect its degree of liquidity.

Question 7

Management of Money Market Securities

Answer 7

Banks can ensure sufficient liquidity by using most of their funds to
purchase short term Treasury securities or other money market securities.

Banks must be concerned about achieving a reasonable return on their assets,
which often conflicts with the liquidity objective. A proper balance must be
maintained.

Question 8

Management of Loans

Answer 8

The secondary market for loans has improved the liquidity, however this
liquidity may lessen as economic condition lessens and demand for selling
loans increases.

Question 9

Use of Securitization to Boost Liquidity

Answer 9

The ability to securitize assets such as automobile and mortgage loans can
enhance a bank’s liquidity.
▪ The process of securitization involves the sale of assets by the bank to a
trustee, who issues securities that are collateralized by the assets.
▪ Collateralized Loan Obligations
▪ Commercial banks can obtain funds by packaging their commercial loans with
those of other financial institutions.
▪ Liquidity Problems
▪ Typically preceded by other financial problems such as major defaults on their
loans.

Question 10

Managing Interest Rate Risk

Answer 10

Net Interest Margin (spread) is the difference between interest payments
received and interest paid:
▪ During a period of rising interest rates, a bank’s net interest margin will likely
decrease if its liabilities are more rate sensitive than its assets. (Exhibit 19.2)
▪ The deposit rates will typically be more sensitive if their turnover is quicker.
(Exhibit 19.3)
▪ A bank measures the risk and then uses its assessment of future interest rates to
decide whether and how to hedge the risk.
10

Question 11

Impact of Increasing Interest Rates on a Bank’s Net Interest
Margin (if the Bank’s Liabilities are More Sensitive Than Its Assets)

Answer 11

Question 12

Impact of Decreasing Interest Rates on a Bank’s Net Interest
Margin (if the Bank’s Liabilities are More Sensitive Than Its Assets)

Answer 12

Question 13

Methods Used to Assess Interest Rate Risk

Answer 13

Gap Analysis Banks can attempt to determine their interest rate risk by
monitoring their gap over time (Exhibit 19.4), where:
Gap = Rate
sensitive assets - Rate sensitive liabilities

An alternative formula is the gap ratio , which is measured as the volume of rate
sensitive assets divided by rate sensitive liabilities.

Many banks classify interest sensitive assets and liabilities into various
categories based on the timing in which interest rates are reset.

Question 14

Interest Sensitive Assets and Liabilities: Illustration of the
Gap Measured for Various Maturity Ranges for Deacon Bank

Answer 14

Question 15

Methods Used to Assess Interest Rate Risk

Answer 15

Duration Measurement

Question 16

Duration Gap

Answer 16

The bank can then estimate its duration gap, which is measured as the
difference between the weighted duration of the bank’s assets and the
weighted duration of its liabilities, adjusted for the firm’s asset size:

Question 17

Regression Analysis

Answer 17

A bank can assess interest rate risk by determining how performance has
historically been influenced by interest rate movements.

This requires that proxies be identified for bank performance and for prevailing
interest rates and that a model be chosen that can estimate their relationship.

When a bank uses regression analysis to determine its sensitivity to interest rate
movements, it may combine this analysis with the value at risk (VaR) method to
determine how its market value would change in response to specific interest rate
movements.
17

Question 18

Whether to Hedge Interest Rate Risk

Answer 18

A bank can consider the measurement of its interest rate risk along with its
forecast of interest rate movements to determine whether it should consider
hedging that risk.

Question 19

Methods Used to Reduce Interest Rate Risk

Answer 19

Maturity matching

Using floating rate loans

Using interest rate futures contracts

Using interest rate swaps

Using interest rate caps

Question 20

Framework for Managing Interest
Rate Risk

Answer 20

Question 21

Methods Used to Reduce Interest Rate Risk

Answer 21

Maturity Matching Match each deposit’s maturity with an asset of the
same maturity.

Using Floating Rate Loans Allows banks to support long term assets
with short term deposits without overly exposing themselves to interest rate
risk.
21

Question 22

Methods Used to Reduce Interest Rate Risk

(Cont)

Answer 22

Using Interest Rate Futures Contracts

Interest rate futures contracts lock in the price at which financial instruments can
be purchased or sold on a specified future settlement date.

Financial futures contracts can reduce the uncertainty about a bank’s net interest
margin. (Exhibit 19.6)

Using Interest Rate Swaps An arrangement to exchange periodic cash
flows based on specified interest rates. (Exhibits 19.7 & 19.8)

Question 23

Effect of Financial Futures on the Net Interest Margin of
Banks That Have More Rate Sensitive Liabilities Than Assets

Answer 23

Question 24

Illustration of an Interest Rate Swap

Answer 24

Question 25

Comparison of Denver Bank’s Spread: Unhedged versus Hedged

Answer 25

Question 26

Using Interest Rate Caps

Answer 26

Agreements (for a fee) to receive payments when the interest rate of a particular security or index rises above a specified level during a specified time period.  During periods of rising interest rates, the cap provides compensation that can offset the reduction in spread during such periods.

Question 27

International Interest Rate Risk

Answer 27

When a bank has foreign currency balances, the strategy of matching the overall interest rate sensitivity of assets to that of liabilities will not automatically achieve a low degree of interest rate risk.

Question 28

Managing Credit Risk (1 of 6)

Answer 28

Measuring Credit Risk : Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness.  Determining the Collateral  When a bank assesses a request for credit, it must decide whether to require collateral that can back the loan in case the borrower is unable to make the payments.  Determining the Loan Rate  If the bank decides to grant the loan, it can use its evaluation of the firm to determine the appropriate interest rate.  Some loans to high quality (low risk) customers are commonly offered at rates below the prime rate.

Question 29

Measuring Credit Risk of a Bank Portfolio

Answer 29

Exposure is dependent on types of loans a bank provides.  Larger proportion of financing credit cards increases exposure to credit risk.  Exposure also changes over time in response to economic conditions.

Question 30

Trade off between Credit Risk and Return

Answer 30

If a bank wants to minimize credit risk, it can use most of its funds to purchase Treasury securities.  A bank concerned with maximizing its return could use most of its funds to provide credit card and consumer loans.

Question 31

Expected Return and Risk of Subprime Mortgage Loans

Answer 31

Many commercial banks aggressively funded subprime mortgage loans in the 2004 2006 period by originating the mortgages or purchasing mortgage backed securities that represented subprime mortgages.  The banks did not anticipate the credit crisis that occurred in the 2008 2009 period and that the value of many homes would decline far below the amount owed on the mortgage.

Question 32

Reducing Credit Risk

Answer 32

Industry Diversification of Loans Banks should diversify their loans to ensure that their customers are not dependent on a common source of income.  International Diversification of Loans Many banks reduce their exposure to U.S. economic conditions by diversifying their loan portfolio internationally.

Question 33

Reducing Credit Risk | (Cont)

Answer 33

Selling Loans Banks can eliminate loans that are causing excessive risk to their loan portfolios by selling them in the secondary market.  Revising the Loan Portfolio in Response to Economic Conditions Banks continually assess both the overall composition of their loan portfolios and the economic environment.

Question 34

Managing Market Risk (1 of 3)

Answer 34

Market risk results from changes in the value of securities due to changes in financial market conditions such as interest rate movements, exchange rate movements, and equity prices.  As banks pursue new services related to the trading of securities, they have become much more susceptible to market risk.  The increase in banks’ exposure to market risk is also attributed to their increased participation in the trading of derivative contracts.

Question 35

Measuring Market Risk

Answer 35

Banks commonly measure their exposure to market risk by applying the value at risk (VaR) method, which involves determining the largest possible loss that would occur as a result of changes in market prices based on a specified percent confidence level.  Bank Revisions of Market Risk Measurements Banks continually revise their estimate of market risk in response to changes in their investment and credit positions and to changes in market conditions.  Relationship between a Bank’s Market Risk and Interest Rate Risk Partially dependent on its exposure to interest rate risk.

Question 36

Methods Used to Reduce Market Risk

Answer 36

Could reduce the amount of transactions in which it serves as guarantor for its clients or reduce the bank’s investment in foreign debt securities that are subject to adverse events in a specific region.  Could attempt to take some trading positions to offset some of its exposure to market risk.  Could sell some of its securities that are heavily exposed to market risk.

Question 37

Integrated Bank Management (1 of 2) Application

Answer 37

Exhibits 19.9, 19.10, & 19.11.  Could attempt to take some trading positions to offset some of its exposure to market risk.

Question 38

Balance Sheet of Atlanta Bank (in Millions of Dollars)

Answer 38

Question 39

Comparative Balance Sheet of Atlanta Bank

Answer 39

Question 40

Evaluation of Atlanta Bank Based on its Balance Sheet

Answer 40

Question 41

Management of Bank Capital

Answer 41

Question 42

Exchange Rate Risk

Answer 42

When a bank providing a loan requires that the borrower repay in the currency denominating the loan, it may be able to avoid exchange rate risk.

Question 43

Settlement Risk

Answer 43

International banks that engage in large currency transactions are exposed not only to exchange rate risk as a result of their different currency positions but also to settlement risk, or the risk of a loss due to settling their transactions.

Question 44

SUMMARY (1 of 5)

Answer 44

The underlying goal of bank management is to maximize the wealth of the bank’s shareholders, which implies maximizing the price of the bank’s stock (if the bank is publicly traded). A bank’s board of directors needs to monitor bank managers to ensure that managerial decisions are intended to serve shareholders.  Banks manage liquidity by maintaining some liquid assets such as short term securities and ensuring easy access to funds (through the federal funds market).

Question 45

SUMMARY (2 of 5)

Answer 45

Banks measure their sensitivity to interest rate movements so that they can assess their exposure to interest rate risk. Common methods of measuring interest rate risk include gap analysis, duration analysis, and measuring the sensitivity of earnings (or stock returns) to interest rate movements. Banks can reduce their interest rate risk by matching the maturities of their assets and liabilities or by using floating rate loans to create more rate sensitivity in their assets. Alternatively, they could sell financial futures contracts or engage in a swap of fixed rate payments for floating rate payments.

Question 46

SUMMARY (3 of 5)

Answer 46

Banks manage credit risk by carefully assessing the borrowers who apply for loans and by limiting the amount of funds they allocate toward risky loans (such as credit card loans). They also diversify their loans across borrowers of different regions and industries so that the loan portfolio is not overly susceptible to financial problems in any single region or industry.

Question 47

SUMMARY (4 of 5)

Answer 47

Banks commonly measure their exposure to market risk by using the value at risk method, which determines the largest possible loss that could occur due to changes in market conditions based on a specified confidence level. They can lower their exposure to market risk by changing their investments, taking offsetting trading positions, or reducing involvement in activities that lead to high exposure.

Question 48

SUMMARY (5 of 5)

Answer 48

An evaluation of a bank includes assessment of its exposure to interest rate movements and to credit risk. This assessment can be used along with a forecast of interest rates and economic conditions to forecast the bank’s future performance.  Banks engaged in international banking face exchange rate risk, which can be hedged in various ways, and settlement risk.