Lecture 18 I. Background on Commercial Banks II. Bank Sources of Funds III. Uses of Funds by banks IV.Off Balance Sheet ActivitiesOutline of Current Lecture I. Banks, Goals, Strategies, and governanceII. managing liquidityIII. managing interest rate riskIV. Gap analysisV. managing credit riskVI. managing market riskVII. Managing risk of international operationCurrent LectureVIII. Banks, Goals, Strategies, and governance1. ■What is the underlying goal of bank’s management?■Maximize shareholder wealth, make as many loans as you can and make good investments, banks have ton of risk■Aligning Managerial Compensation with Bank Goals■How can a bank align compensation with bank’s goals?■If bank fails, people with savings lose, their stocks go to 0 and people lose their jobs■Bank Strategy■ What is a bank’s strategy with regards to making money and mitigating risk? They pay people with either commission or salary. Bank officers no commission. Mortgage officers, commission cause they sell off the loans. ■ Way they pay (salaries)■To implement their strategy, commercial banks rely heavily on financial markets.■Outside to help guide them on making smart decisions, they arent the ones getting paid FI 301 1st Edition■Inside is conflict of interest because they can give themselves raises or bonusesIX. managing liquidity1. How can a bank have illiquidity issues?Whether they have enough cash or not, banks can become illiquidBank run- too many withdrawal at one time Failed investments, loose all of the moneyLoan all of their money out, loan more than they have sitting in the bank- banks have liabilities too such as savings and money marketsUse of Securitization to Boost Liquidity■What is securitization and how does the bank make money from securitization?■■Solve it? Securitization where you sell your mortgages, they loan a bunch of loans and they are becoming illiquid, pull them together and sell to freddie mac or fannie mae. ■Buy treasuries- these help because treasuries are liquid, sell them and get plenty of cash to put back in your faultX. managing interest rate risk1. Methods Used to Assess Interest Rate Risk■Gap Analysis - Banks can attempt to determine their interest rate risk by monitoring their gap over time, where:Gap = Rate-sensitive assets – Rate-sensitive liabilities■An alternative formula is the gap ratio. ■Gap Ratio = Rate-sensitive assets / rate-sensitive liabilities.■Many banks classify interest-sensitive assets and liabilities into various categories based on the timing in which interest rates are reset.XI. Gap analysis1. Net interest margin- 80 mil-35 mil/1 billion= .045= 4.5% banks spread profitable or notGap= 400-700= -300 bank has a problem with interest rate riskGap Ratio- 400/700= less than 1 the bank has got a problem■Maturity matching- try to have similar length loans to our similar length accounts liabilities toassets■■Using-floating rate loans- interest rate changes with the market if interest rate goes uprapidly loan goes up rapidly. Adjustable rates■■Using interest rate futures contracts, interest rate swaps and interest rate caps■Hedge- if theyre loaning and expect rates to go up buy derivative hedging a changing interest rates one way or the other XII. managing credit risk1. Measuring Credit Risk: Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness.■Default risk the fear that people wont pay their loans■What do banks use to measure credit?■Test this by running your credit FICO, FICO stands for FAIR Isaac Corporation. Want as close to 850 as you can get. You need to pay on time over a long period of time. Helps you get lower interest rates. ■What do banks typically use for collateral? What do they use to measure the collateral? Real estate loans good collateral, car loan would be a car. The way they measure that is with a real estate appraisal■Example: Subprime Mortgage Loans■When times start getting rough, crisis started happening, the risk of the loans defaulted. Subprime defaulted to 30 percent rate. Prime loans 10 percent rate.■Why did banks make subprime loans and buy subprime mortgage backed securities?■Subprime is higher interest but have a higher risk of not getting paid back. ■What happened once a problem occurred?■Most recent financial crisis was because of credit risk. Banks were loaning to people who didn’teven have a job ■The banks failed and they were not making enough money the government had to bail them outXIII. managing market risk1. §Market risk results from changes in the value of securities due to changes in financial market conditions such as interest rates, currency exchange rates and equity prices.§Fear of market falling as a whole§So how do banks have market risk?§Stocks, currencies, commodity prices rise and fall against you . They have loans and investment that deals with interest rates. §What is the value-at-risk (VaR) method? §This is how they assess it. Measures lossesXIV. Managing risk of international operation1. exchange rate risk1. ■Where would a bank have this risk? ■Bank making a loan overseas, buying products over seas■How can they avoid it? ■Don’t loan overseas or people internationally. Bankers acceptance for example if the currency changes and people cant afford to pay you back.■■If they avoid this risk, what other problems may the bank have?■You are not diversifiedRisk Assess Solve1)Liquidity Cash on hand Securitization, Treasuries2)Interest Rate Gap, Duration, Regression Hedge, Floating, Rate Loans, Maturity Matching3)Credit FICO, Collateral Diversify Loans, Securitization4)Market VAR Quit Loans, Quit