© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Markets and Institutions Abridged 10th Edition by Jeff Madura 1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■ describe the underlying goal, strategy, and governance of banks ■ explain how banks manage liquidity ■ explain how banks manage interest rate risk ■ explain how banks manage credit risk ■ explain integrated bank management 19 Bank Management Chapter Objectives 2© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Goals, Strategy, and Governance 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. 3© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 19.1 Participation of Commercial Banks in Financial Markets 4© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Goals, Strategy, and Governance Bank Governance by the Board of Directors 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. 5© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Goals, Strategy, and Governance Bank Governance by the Board of Directors ■ Inside versus Outside Directors ■ 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. 6© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bank Goals, Strategy, and Governance Other Forms of Bank Governance ■ 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. 7© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managing Liquidity ■ Banks can experience illiquidity when cash outflows (due to deposit withdrawals, loans, etc.) exceed cash inflows (new deposits, loan repayments, etc.). ■ 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. 8© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managing Liquidity Use of Securitization to Boost Liquidity ■ 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. 9© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managing Interest Rate Risk ■ 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. ■ The deposit rates will typically be more sensitive if their turnover is quicker. ■ A bank measures the risk and then uses its assessment of future interest rates to decide whether and how to hedge the