Bank Management and Financial Services 8e - Peter S. Rose, Sylvia C. Hudgins

Chapter One
An Overview of the
Changing Financial-
Services Sector
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
Key Topics
• Powerful Forces Reshaping the Industry

• What Is a Bank?
• The Financial System and Competing
Financial-Service Institutions
• Old and New Services Offered to the Public
• Key Trends Affecting All Financial-Service
Firms
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e
1-3
The Different Kinds of Financial Service

Firms Calling Themselves Banks
• Commercial Banks • Limited Purpose Banks
• Savings Banks • Bankers’ Banks
• Cooperative Banks • Minority Banks
• Mortgage Banks • National Banks
• Community Banks • State Banks
• Money Center Banks • Insured Banks
• Investment Banks • Member Banks
• Merchant Banks • Affiliated Banks
• International Banks • Virtual Banks
• Wholesale Banks • Fringe Banks
• Retail Banks • Universal Banks
McGraw-Hill/Irwin
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The Financial Service Competitors of Banks

• Savings Associations
• Credit Unions
• Money Market Funds
• Mutual Funds (Investment Companies)
• Hedge Funds
• Security Brokers and Dealers
• Investment Banks
• Finance Companies
• Financial Holding Companies
• Life and Property-Casualty Insurance Companies
McGraw-Hill/Irwin
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Quick Quiz
• What is a bank? How does a bank differ
from most other financial-service
providers?
• Under current U.S. federal law what must a

corporation do to qualify and be regulated
as a commercial bank?
• What is happening to banking’s share of the

financial marketplace and why?
McGraw-Hill/Irwin
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Traditional Services Offered By Banks
• Carrying Out Currency Exchange

• Discounting Commercial Notes and Making
Business Loans
• Offering Savings Deposits
• Safekeeping of Valuables
• Supporting Government Activities with
Credit
• Offering Checking Accounts
• Offering Trust Services
McGraw-Hill/Irwin
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More Recent Services Offered by

Banks
• Granting Consumer Loans
• Providing Financial Advice
• Managing Cash
• Offering Equipment Leasing
• Making Venture Capital Loans
• Selling Insurance Policies
• Selling Retirement Plans
McGraw-Hill/Irwin
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Offering Security Brokerage and

Investment Banking Services
• Underwriting Securities
• Offering Mutual Funds and Annuities
• Offering Merchant Banking Services
• Offering Risk Management and Hedging
Services
McGraw-Hill/Irwin
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Trends Affecting Banks and Other

Financial Service Firms Today
• Service Proliferation
• Rising Competition
• Government Deregulation
• Increased Interest Rate Sensitivity
• Technological Change and Automation
• Consolidation and Geographic Expansion
• E-Banking and E-Commerce
• Convergence
• Globalization
McGraw-Hill/Irwin
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Quick Quiz
• Why do banks and other financial

intermediaries exist in modern society,
according to the theory of finance?
• How have banking and the financial services

market changed in recent years?
• What powerful forces are shaping financial

markets and institutions today? Which of
these forces do you think will continue into
the future?
McGraw-Hill/Irwin
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Web Links
• Federal Deposit Insurance Company www.fdic.gov

• Federal Financial Institutions Examination Council
www.ffiec.gov
• Office of Thrift Supervision www.ots.treas.gov
• Credit Union National Association www.cuna.org
• Morningstar, Inc. http://www.morningstar.com
• Security and Exchange Commission www.sec.gov
• Careers in Finance www.careers-in-finance.com
• Bank Job Search www.bankjobsearch.com
• Bank Jobs www.bankjobs.com
McGraw-Hill/Irwin
Chapter Three
The Organization and
Structure of Banking
and the Financial-
Services Industry
3-13
Key Topics
• The Organization and Structure of the

Commercial Banking Industry
• The Array of Organizational Structures in
Banking
• Interstate Banking and the Riegle-Neal Act
• The Financial Holding Company
• Mergers and Acquisition
• Banking Structure and Organization in Europe
and Asia
• The Changing Organization and Structure of
Banking’s Principal Competitors
• Economies of Scale and Scope
McGraw-Hill/Irwin
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Assets Held by U.S. FDIC-Insured

Commercial Banks, 2007
2%
11%
Assets Held By Large
Banks
Assets Held By Medium
Banks
Assets Held By Small Banks
87%
McGraw-Hill/Irwin
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Number of U.S. FDIC-insured

Commercial Banks, 2007
7%
43% Small ≤ $100 Million
50% Medium $100 Million -

$1 Billion
Large > $1 Billion
McGraw-Hill/Irwin
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Community Banks or Retail Banks

• ‘Typical’ Size is $300 Million
• Organizational Chart is Not Complicated
• Significantly Affected by Health of Local
Economy
• Generally Know their Customers Well –
Relationship Lending
McGraw-Hill/Irwin
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Money Center or Wholesale Banks
• Generally Multi-Billion Dollar Company

• Organizational Chart is Much More Complex
• Serve Many Different Markets with Many
Different Services so are Better Diversified
Geographically and by Product
• Able to Raise Large Amounts of Capital at
Relatively Low Costs
McGraw-Hill/Irwin
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Quick Quiz
• What are the general trends in the size
distribution and asset concentration of
American banking industry?
• Describe differences between a typical
organizational structure of smaller
community bank and a larger money-center
bank.
• What trends are affecting the way banks
and their competitors are organized today?
McGraw-Hill/Irwin
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Common Classifications of U.S. Banks

FDI C I ns ur ed B ank s 98%
Not FDI C I ns ur ed 2%
0% 20% 40% 60% 80% 100% 120%
Nat i onal B anks 25%
St at e B anks 75%
0% 10% 20% 30% 40% 50% 60% 70% 80%
M ember B anks 36%
Non M ember B anks 64%
0% 10% 20% 30% 40% 50% 60% 70%
Source: FRB and FDIC, 2005

McGraw-Hill/Irwin
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Deposits Held By Banks

Deposi t s of Nat i onal B anks 55%
Deposi t s of St at e B anks 45%
0% 10% 20% 30% 40% 50% 60%
Deposi t s of M ember B anks 77%
Deposi t s of Non M ember B anks 23%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Source: FRB and FDIC, 2005

McGraw-Hill/Irwin
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Unit Banks
• Offer All Services From One Office

• One of the Oldest Kinds of Banks
• New Banks are Generally Unit Banks Until
Can Grow and Attract More Resources
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Branch Banks
• Offer Full Range of Services from Several
Locations
• Senior Management at the Home Office
• Each Branch has its Own Management Team
with Limited Decision Making Ability
• Some Functions are Highly Centralized,
While Others are Decentralized
McGraw-Hill/Irwin
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Reasons for Growth of Branching
• Exodus of Population to Suburban

Communities
• Increased Bank Failures in Recent Years
• Business Growth
McGraw-Hill/Irwin
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What Trend in Branch Banking Has Been

Prominent in the U.S. in Recent Years?
Year # of Bank # of Total of Ave # of
Main Branch U.S. Bank Branches/
Offices Offices Offices U.S. Bank
1934 14,146 2,985 17,131 0.21
1970 13,511 21,810 35,321 1.61
1982 14,451 39,784 54,235 1.75
2007 7,241 77,947 85,188 10.76
From Table 3-2; Source: FDIC

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Electronic Branches
• Internet Banking Services
• Automated Teller Machines (ATMs)
• Point of Sale (POS) Terminals
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Virtual Banks
• Provide their Services Exclusively Through

the Web
• Can Generate Cost Savings Over Traditional
Brick-and-Mortar Banks
• Have Not Yet Demonstrated They Can Be
Consistently Profitable
McGraw-Hill/Irwin
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Bank Holding Companies (BHC)
• A Corporation Chartered for the Purpose of

Holding the Stock of One or More Banks
• Control of a bank is Assumed When 25% or
More of the Stock is Owned
• Must Get Approval from Federal Reserve
Board to Control a Bank
• One-Bank Holding Companies vs. Multibank
Holding Companies
McGraw-Hill/Irwin
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Organizational Structure of a BHC

Single Bank Holding Company
Board of Directors
Parent Company
Each subsidiary has a

Bank Subsidiary Nonbank Subsidiaries
president and line officers
Bank Branches
The bottom four levels have the same organizational form as the independent bank.
Multibank Holding Company
Board of Directors
Parent Company
Bank Subsidiary Nonbank Subsidiaries Bank Subsidiary
McGraw-Hill/Irwin
Bank Branches Bank Branches
3-29
Nonbank Businesses of BHCs

• Finance Companies • Investment Banking
• Mortgage Companies Firms
• Data Processing • Trust Companies
Companies • Credit Card
• Factoring Companies Companies
• Security Brokerage • Leasing Companies
Firms • Insurance Companies
• Financial Advising and Agencies
• Credit Insurance • Real Estate Services
Underwriters • Savings Associations
• Merchant Banking
McGraw-Hill/Irwin
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Reasons for the Growth of BHCs
• Geographic Diversification
• Product Line Diversification
• Tax Sheltering
• Double Leveraging
• Source of Strength
• A Way Around Regulatory Restrictions
McGraw-Hill/Irwin
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Reasons for Full-Service Interstate

Banking
• Need to Bring New Capital to Revive
Struggling Local Economies
• The Expansion by Non Bank Financial
Institutions with Fewer Restrictions
• A Strong Desire by Large Banks to Expand
Geographically
• Belief Among Regulators that Large Banks
are More Efficient and Less Prone to Failure
• Advances in Technology
McGraw-Hill/Irwin
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Riegle-Neal Interstate Banking and

Branching Efficiency Act of 1994
• Allows BHCs to Acquire Banks Anywhere in
the U.S.
• Allows BHCs to Convert Banks to Branches –
June 1997
• States Can ‘Opt Out’ and Not Allow BHCs to
Convert to Branches
• States Can ‘Opt In’ Early
• Limits Deposits of One BHC to 10%
Nationwide and 30% Within One State
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Proponents and Opponents of

Interstate Banking
Proponents Opponents
• Efficient Use of Scarce • Increased Bank
Resources Concentration
• Lower Prices for Services • Less Competition
• Geographic Diversification • Higher Prices for Services
• Efficient Flow of Credit in • Drain Resources from
the System Community
McGraw-Hill/Irwin
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Financial Holding Companies: GLB

Act of 1999
• Special Type of Holding Company
• Offers the Broadest Range of Services
• List of Activities Offered May Expand as
Regulators Decide What Services are
‘Compatible’ with Banking
• Each Affiliated Financial Firm has its Own
Capital and Management and its Own Profit
or Loss
McGraw-Hill/Irwin
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Sample Organizational Structure of FHC
Financial Holding
Company
Bank Securities Real

Insurance Thrift Holding
Subsidiaries
Holding Subsidiary Company Estate
Company Subsidiary
Subsidiaries
Commercial Nonbank Thrift Company and Service
Banking Subsidiaries Companies
Company
McGraw-Hill/Irwin
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Bank Subsidiaries
• Bank Controls One or More Subsidiaries

• Subsidiaries Offer Other Services Such as
Insurance and Security Brokerage Services
• Profits and Losses of Each Subsidiary Impact
Parent Bank
McGraw-Hill/Irwin
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The Changing Organization and

Structure
• Rise in Branching, BHCs, and FHCs
• Consolidation among Banks and Nonbanks
• Convergence
• Other forces of change:
▫ Deregulation/Reregulation
▫ Financial Innovation
▫ Securitization
▫ Globalization
▫ Advances in Technology
McGraw-Hill/Irwin
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Do Bigger Firms Operate at Lower

Cost?
• Economies of Scale
• Exhibit 3-10
• Economies of Scope
• Banking and Financial Firm Goals and
Motivations
• Expense-Preference Behavior
• Agency Theory
• Corporate Governance
McGraw-Hill/Irwin
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Structure and Organization of

Banks in Europe
• Germany – Largest European Banking
Industry
▫ Private Sector Banks
▫ Public Sector Banks
• France – Second in Number of Banks
• Belgium – Dominated by Five Large Banks
• Great Britain – Dominated by a Half Dozen
Banking Firms
• Switzerland – Credit Suisse and UBS and
Many Smaller Firms
• Italy Privatized Banking in the 1990’s
McGraw-Hill/Irwin
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Structure and Organization of

Banks in Asia
• China – Large Dominating Government
Sector, Although Private Banks are
Expanding
• Japan – Dominated by the Big Four Financial
Group with More than One Hundred Smaller
Domestic Banks and Seventy Foreign Banks
McGraw-Hill/Irwin
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Quick Quiz
• Which type of corporations chartered for the
simple purpose of holding the stock of at least
one bank?
• What were the reasons for the Riegle Neal Act
of1994?
• When the banking industry moves toward
larger but fewer organizations, what is it
known as?
• What relationship appears to exist between
bank size, efficiency, and operating costs per
unit of service produced and delivered?
McGraw-Hill/Irwin
Chapter Five
The Financial
Statements of Banks
and Their Principal
Competitors
5-43
Key Topics
• An Overview of the Balance Sheets and Income
Statements of Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance Sheet Items
• The Problem of Book-Value Accounting and
"Window Dressing"
• Components of the Income Statement:
Revenues and Expenses
McGraw-Hill/Irwin
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Bank Financial Statements
• Report of Condition – Balance Sheet
• Report of Income – Income Statement
McGraw-Hill/Irwin
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Report of Condition
• The Balance Sheet of a Bank Showing its

Assets, Liabilities and Net Worth at a given
point in time
• May be viewed as a list of financial inputs

(sources of funds) and outputs (uses of
funds)
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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C + S + L + MA = D + NDB + EC
C = Cash Assets
D = Deposits
NDB = Nondeposit
S = Security Holdings Borrowings
L = Loans EC = Equity Capital
MA = Miscellaneous Assets
McGraw-Hill/Irwin
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Cash Assets
• Account is Called Cash and Deposits Due

from Bank
• Includes:
▫ Vault Cash
▫ Deposits with Other Banks (Correspondent
Deposits)
▫ Cash Items in Process of Collection
▫ Reserve Account with the Federal Reserve
• Sometimes Called Primary Reserves
McGraw-Hill/Irwin
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Securities: The Liquid Portion
• Often Called Secondary Reserves

• Include:
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
 Interest Bearing Time Deposits
 Commercial Paper
McGraw-Hill/Irwin
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Investment Securities
• These are the Income Generating Portion of

Securities
• Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
• Tax-Exempt Securities
▫ Municipal Bonds
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Trading Account Assets
• Securities purchased to Provide Short-Term

Profits from Short-Term Price Movements
• When the Bank Acts as a Securities Dealer
• Valued at Market – FASB 115
McGraw-Hill/Irwin
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Federal Funds Sold and Reverse

Repurchase Agreements
• A Type of Loan Account
• Generally Overnight Loans
• Federal Funds Sold - Funds Come from the
Deposits at the Federal Reserve
• Reverse Repurchase Agreements – Bank
Takes Temporary Title to Securities Owned
by Borrower
McGraw-Hill/Irwin
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Loan Accounts
• The Major Asset
• Gross Loans – Sum of All Loans
• Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses
• Net Loans
• Unearned Discount Income
• Nonperforming Loans
McGraw-Hill/Irwin
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Types of Loans
• Commercial and Industrial Loans
• Consumer Loans (Loans to Individuals)
• Real Estate Loans
• Financial Institution Loans
• Foreign Loans
• Agriculture Production Loans
• Security Loans
• Leases
McGraw-Hill/Irwin
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Allowance for Loan Losses
Beginning ALL
+ Provision for Loan Loss (Income Statement)
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
McGraw-Hill/Irwin
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Specific and General Reserves
• Specific Reserves
▫ Set Aside to Cover a Particular Loan
▫ Designate a Portion of ALL or
▫ Add More Reserves to ALL
• General Reserves
▫ Remaining ALL
• Determined by Management But Influenced
by Taxes and Government Regulation
• Loans to Lesser Developed Countries
Require Allocated Transfer Reserves
McGraw-Hill/Irwin
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Miscellaneous Assets
• Bank Premises and Fixed Assets
• Other Real Estate Owned (OREO)
• Goodwill and Other Intangibles
McGraw-Hill/Irwin
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Deposit Accounts
• Non interest-Bearing Demand Deposits

• Savings Deposits
• Now Accounts
• Money Market Deposit Accounts (MMDA)
• Time Deposits
McGraw-Hill/Irwin
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Nondeposit Borrowings
• Fed Funds Purchased
• Securities Sold Under Agreement to
Repurchase (Repurchase Agreements)
• Acceptances Outstanding
• Eurocurrency Borrowings
• Subordinated Debt
• Limited Life Preferred Stock
• Other Liabilities
McGraw-Hill/Irwin
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Equity Capital
• Preferred Stock
• Common Stock
▫ Common Stock Outstanding
▫ Capital Surplus
▫ Retained Earnings (Undivided Profits)
▫ Treasury Stock
▫ Contingency Reserve
McGraw-Hill/Irwin
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Off-Balance-Sheet Items
• Unused Commitments
• Standby Credit Agreements
• Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
• OBS Transactions Exposure a Firm to
Counterparty Risks
McGraw-Hill/Irwin
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Possible Issues
• The Problem with Book-Value Accounting
▫ Original (historical, book-value) cost
▫ Amortized cost
▫ Market-value
▫ Held-to-maturity and available-for-sale
securities
• Window Dressing
• Auditing Financial Statements
▫ Audit Committees
▫ Sarbanes-Oxley Accounting Standards Act
McGraw-Hill/Irwin
5-63
Comparative
Balance Sheet
Ratios for
Different Size
Banks (FDIC,
2006)
Which accounts are most important on the asset side of a Call Report? Liability side?
McGraw-Hill/Irwin
5-64
Quick Quiz
• Which are the principal accounts that
appear on a bank’s balance sheet (Report of
Condition)?
• What are primary reserves and secondary
reserves, and what are they supposed to
do?
• What are off-balance-sheet items, and why
are they important to some financial firms?
McGraw-Hill/Irwin
5-65
Report of Income
• The Statement of Revenues, Expenses and Profits

for a Bank Over a Period of Time
• Shows how much it has cost to acquire funds and

to generate revenues from the uses of funds in
Report of Conditions
• Shows the revenues (cash flow) generated by

selling services to the public
• Shows net earnings after all costs are deducted

from the sum of all revenues
McGraw-Hill/Irwin
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Report of
Income for
BB&T
Corporation
McGraw-Hill/Irwin
5-67
Net Interest Income =

Interest Income – Interest Expenses
Interest Income Interest Expenses
• Interest and Fees on Loans • Deposit Interest Costs
• Taxable Securities Revenue • Interest on Short-Term
• Tax-Exempt Securities Debt
Revenue • Interest on Long-Term Debt
• Other Interest Income
McGraw-Hill/Irwin
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Net Noninterest Income =

Noninterest Income – Noninterest Expenses
Noninterest Income Noninterest Expenses

• Fees Earned from Fiduciary • Wages, Salaries, and
Activities Employee Benefits
• Service Charges on Deposit
Accounts • Premises and Equipment
Expense
• Trading Account Gains and
Fees • Other Operating Expenses
• Additional Noninterest
Income
McGraw-Hill/Irwin
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Fees Earned from Fiduciary Activities
• Fees for Managing Protecting a Customer’s

Property
• Fees for Record Keeping for Corporate
Security Transactions and Dispensing
Interest and Dividend Payments
• Fees for Managing Corporate and Individual
Pension and Retirement Plans
McGraw-Hill/Irwin
5-70
Service Charges on Deposit Accounts
• Checking Account Maintenance Fees

• Checking Account Overdraft Fees
• Fees for Writing Excessive Checks
• Savings Account Overdraft Fees
• Fess for Stopping Payment of Checks
McGraw-Hill/Irwin
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Trading Account Gains and Fees
• Net Gains and Losses from Trading Cash

Instruments and Off Balance Sheet
Derivative Contracts That Have Been
Recognized During the Accounting Period
McGraw-Hill/Irwin
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Additional Noninterest Income

• Investment Banking, Advisory, Brokerage
and Underwriting
• Venture Capital Revenue
• Net Servicing Fees
• Net Securitization Income
• Insurance Commission Fees and Income
• Net Gains (Losses) on Sales of Loans
• Net Gains (Losses) on ales of Real Estate
• Net Gains (Losses) on the Sales of Other
Assets
McGraw-Hill/Irwin
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Income Statement
Net Interest Income

- Provision for Loan Loss
Net Income After PLL
+/- Net Noninterest Income
Net Income Before Taxes
Taxes
Net Income
- Dividends
Undivided Profits
McGraw-Hill/Irwin
5-74
Comparative
Income Statement
Ratios for
Different Size
Banks (FDIC,
2006)
What are the most important revenue and expense items on the income statement
of a bank?
McGraw-Hill/Irwin
5-75
McGraw-Hill/Irwin
5-76
Quick Quiz
• What accounts make up the Report of Income?
• What is the relationship between the provision
for loan losses on a bank’s Report of Income
and the allowance for loan losses on its Report
of Condition?
• Suppose a bank has an allowance for loan losses of
$1.25 million at the beginning of the year, charges
current income for a $250,000 provision for loan
losses, charges off worthless loans of $150,000,
and recovers $50,000 on loans previously charged
off. What will be the balance in the allowance for
loan losses at year-end?
McGraw-Hill/Irwin
Chapter Six
Measuring and Evaluating the
Performance of Banks and
Their Principal Competitors
6-78
Key Topics
• Stock Values and Profitability Ratios

• Measuring Credit, Liquidity, and Other Risks
• Measuring Operating Efficiency
• Performance of Competing Financial Firms
• Size and Location Effects
• The UBPR and Comparing Performance
McGraw-Hill/Irwin
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Value of the Bank’s Stock
McGraw-Hill/Irwin
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Value of a Bank’s Stock Rises When:
• Expected Dividends Increase

• Risk of the Bank Falls
• Market Interest Rates Decrease
• Combination of Expected Dividend Increase
and Risk Decline
McGraw-Hill/Irwin
6-81
Value of Bank’s Stock if Earnings Growth

is Constant
D1
P0 
r-g
McGraw-Hill/Irwin
6-82
Key Profitability Ratios in Banking

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital
Net Income
Return on Assets (ROA) =
Total Assets
(Interestincome
- Interestexpense) Net InterestIncome
Net InterestMargin  
T otalAssets T otalAssets
Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Noninterest Margin  
McGraw-Hill/Irwin T otalAssets T otalAssets
6-83
Key Profitability Ratios in Banking (cont.)
Total Operating Revenues -

Total Operating Expenses
Net Bank Operating Margin 
Total Assets
Net IncomeAfterT axes

EarningsPer Share (EP S) 
CommonEquity Shares Outstanding
Total Interest Income __ Total Interest Expense

Earnings Spread = Total Earning Assets Total Interest Bearing Liability
McGraw-Hill/Irwin
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Breaking Down ROE
ROE = Net Income/ Total Equity Capital
ROA = Equity Multiplier =

Net Income/Total Assets x Total Assets/Equity Capital
Net Profit Margin = x Asset Utilization =

Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
McGraw-Hill/Irwin
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ROE Depends On:

• Equity Multiplier=Total assets/Total equity capital
▫ Leverage or Financing Policies: the choice of
sources of funds (debt or equity)
• Net Profit Margin=Net income/Total operating

revenue
▫ Effectiveness of Expense Management (cost
control)
• Asset Utilization=Total operating revenue/Total

assets
▫ Portfolio Management Policies (the mix and yield
on assets)
McGraw-Hill/Irwin
6-86
Determinants of
ROE in a
Financial Firm
McGraw-Hill/Irwin
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Components of ROE for All Insured U.S.

Banks (1992-2007)
McGraw-Hill/Irwin
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A Variation on ROE
Net Income Pre-Tax Net Operating Income
ROE =  
Pre-Tax Net Operating Income Total Operating Revenue
Total Operating Revenue Total Assets

Total Assets Total Equity Capital
ROE = Tax Management Efficiency 
Expense Control Efficiency 
Asset Management Efficiency 
Funds Management Efficiency
McGraw-Hill/Irwin
6-89
Breakdown of ROA
McGraw-Hill/Irwin
6-90
Quick Quiz
• What individuals or groups are likely to be
interested in the banks’ level of profitability
and exposure to risk?
• What are the principal components of ROE, and
what does each of the these components
measure?
• Suppose a bank has an ROA of 0.80% and an
equity multiplier of 12x. What is its ROE?
Suppose this bank’s ROA falls to 0.60%. What
size equity multiplier must it have to hold its
ROE unchanged?
• What are the most important components of
ROA and what aspects of a financial
institution’s performance do they reflect?
McGraw-Hill/Irwin
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Bank Risks
• Credit Risk • Legal and

• Liquidity Risk Compliance Risk
• Market Risk • Reputation Risk
• Interest Rate Risk • Strategic Risk
• Operational Risk • Capital Risk
McGraw-Hill/Irwin
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Credit Risk
The Probability that Some of the

Financial Firm’s Assets Will
Decline in Value and Perhaps
Become Worthless
McGraw-Hill/Irwin
6-93
Credit Risk Measures

• Nonperforming Loans/Total Loans
• Net Charge-Offs/Total Loans
• Provision for Loan Losses/Total Loans
• Provision for Loan Losses/Equity Capital
• Allowance for Loan Losses/Total Loans
• Allowance for Loan Losses/Equity Capital
• Nonperforming Loans/Equity Capital
McGraw-Hill/Irwin
6-94
Liquidity Risk
Probability the Financial Firm Will

Not Have Sufficient Cash and
Borrowing Capacity to Meet
Deposit Withdrawals and Other
Cash Needs
McGraw-Hill/Irwin
6-95
Liquidity Risk Measures

• Purchased Funds/Total Assets
• Net Loans/Total Assets
• Cash and Due from Banks/Total
Assets
• Cash and Government
Securities/Total Assets
McGraw-Hill/Irwin
6-96
Market Risk: Comprises Price Risk

and Interest Rate Risk
Probability of the Market Value of the

Financial Firm’s Investment Portfolio
Declining in Value Due to a Change in
Interest Rates
McGraw-Hill/Irwin
6-97
Market Risk Measures
• Book-Value of Assets/ Market Value of

Assets
• Book-Value of Equity/ Market Value of
Equity
• Book-Value of Bonds/Market Value of
Bonds
• Market Value of Preferred Stock and
Common Stock
McGraw-Hill/Irwin
6-98
Interest Rate Risk
The Danger that Shifting Interest

Rates May Adversely Affect a Bank’s
Net Income, the Value of its Assets
or Equity
McGraw-Hill/Irwin
6-99
Interest Rate Risk Measures
• Interest Sensitive Assets/Interest

Sensitive Liabilities
• Uninsured Deposits/Total Deposits
McGraw-Hill/Irwin
6-100
Off-Balance-Sheet Risk
The Volatility in Income and Market Value of
Bank Equity that May Arise from
Unanticipated Losses due to OBS Activities
(activities that do not have a balance sheet
reporting impact until a transaction is
affected)
McGraw-Hill/Irwin
6-101
Operational Risk
Uncertainty Regarding a Financial
Firm’s Earnings Due to Failures in
Computer Systems, Errors, Misconduct
by Employees, Floods, Lightening
Strikes and Similar Events or Risk of
Loss Due to Unexpected Operating
Expenses
McGraw-Hill/Irwin
6-102
Legal and Compliance Risk
Risk of Earnings Resulting from Actions

Taken by the Legal System. This can
Include Unenforceable Contracts, Lawsuits
or Adverse Judgments. Compliance Risk
Includes Violations of Rules and Regulations
McGraw-Hill/Irwin
6-103
Reputation Risk
This is Risk Due to Negative Publicity that

can Dissuade Customers from Using the
Services of the Financial Firm. It is the Risk
Associated with Public Opinion.
McGraw-Hill/Irwin
6-104
Capital Risk
Probability of the Value of the Bank’s

Assets Declining Below the Level of its
Total Liabilities. The Probability of the
Bank’s Long Run Survival
McGraw-Hill/Irwin
6-105
Capital Risk Measures
• Stock Price/Earnings Per Share

• Equity Capital/Total Assets
• Purchased Funds/Total Liabilities
• Equity Capital/Risk Assets
McGraw-Hill/Irwin
6-106
Other Goals in Banking

Total Operating Expenses
Operating Efficiency Ratio =
Total Operating Revenues
Net Operating Income

Employee Productivity Ratio =
Number of Full Time-Equivalent Employees
McGraw-Hill/Irwin
6-107
Performance Indicators Related to

the Size of a Firm, 2007
McGraw-Hill/Irwin
6-108
Appendix: UBPR
The Uniform Bank Performance
Report Provided by U.S. Federal
Regulators so that Analysts Can
Compare the Performance of One
Bank Against Another
Web link for UBPR and BHCPR:

www.ffiec.gov
McGraw-Hill/Irwin
Chapter Seven
Risk Management for Changing

Interest Rates: Asset-Liability
Management and Duration Techniques
7-110
Key Topics
• Asset, Liability, and Funds Management

• Market Rates and Interest-Rate Risk
• The Goals of Interest-Rate Hedging
• Interest-Sensitive Gap Management
• Duration Gap Management
• Limitations of Hedging Techniques
McGraw-Hill/Irwin
7-111
Asset-Liability Management
The Purpose of Asset-Liability

Management is to Control a Bank’s
Sensitivity to Changes in Market
Interest Rates and Limit its Losses in
its Net Income or Equity
McGraw-Hill/Irwin
7-112
Historical View of Asset-Liability

Management
• Asset Management Strategy (control
over assets, no control over liabilities)
• Liability Management Strategy (control
over liabilities by changing rates and
other terms)
• Funds Management Strategy (work
with both strategies)
McGraw-Hill/Irwin
7-113
Interest Rate Risk
• Price Risk
▫ When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
• Reinvestment Risk
▫ When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates
McGraw-Hill/Irwin
7-114
Interest Rate Risk: One of the Main

Challenges
• Forces Determining Interest Rates
▫ Loanable Funds Theory
• The Measurement of Interest Rates

▫ YTM
▫ Bank Discount
• Components of Interest Rates
McGraw-Hill/Irwin
7-115
Yield to Maturity (YTM)
n
CFt
Market Price  
t 1 (1  YTM)
t
McGraw-Hill/Irwin
7-116
Bank Discount Rate (DR)
FV - Purchase Price 360

DR  *
FV # Days to Maturity
Where: FV equals Face Value of a Security,

such as Treasury Bills
McGraw-Hill/Irwin
7-117
Market Interest Rates

Function of:
• Risk-Free Real Rate of Interest
• Various Risk Premiums
▫ Default Risk
▫ Inflation Risk
▫ Liquidity Risk
▫ Call Risk
▫ Maturity Risk
McGraw-Hill/Irwin
7-118
Yield Curves
• Graphical Picture of Relationship Between
Yields and Maturities on Securities
• Generally Created With Treasury Securities
to Keep Default Risk Constant
• Shape of the Yield Curve
▫ Upward – Long-Term Rates Higher than Short-
Term Rates
▫ Downward – Short-Term Rates Higher than Long-
Term Rates
▫ Horizontal – Short-Term and Long-Term Rates
the Same
• Shape of the Yield Curve and a Maturity Gap
McGraw-Hill/Irwin
7-119
Net Interest Margin
Interest Income - Interest Expenses

NIM 
Total Earnings Assets
McGraw-Hill/Irwin
7-120
Goal of Interest Rate Hedging
One Important Goal of Interest Rate

Hedging is to Insulate the Bank from
the Damaging Effects of Fluctuating
Interest Rates on Profits
McGraw-Hill/Irwin
7-121
Quick Quiz
• What forces cause interest rates to change?
• What makes it so difficult to correctly forecast
interest rate changes?
• What is the yield curve, and why is it important
to know about its shape and slope?
• What is the goal of hedging?
• First National Bank of Bannerville has posted interest
revenues of $63 million and interest costs from all of its
borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s
net interest margin? Suppose the bank’s interest
revenues and interest costs double, while its earning
assets increase by 50%. What will happen to its net
interest margin?
McGraw-Hill/Irwin
7-122
Interest-Sensitive Gap Measurements
Dollar Interest- Interest-Sensitive Assets –

Sensitive Gap = Interest Sensitive Liabilities
Relative
Dollar IS Gap
Interest- 
Sensitive Gap Bank Size
Interest InterestSensitiveAssets
Sensitivity 
InterestSensitiveLiabilities
Ratio
McGraw-Hill/Irwin
7-123
Examples of Repriceable (Interest

Sensitive) Assets and Liabilities
McGraw-Hill/Irwin
7-124
Asset-Sensitive Bank Has:
• Positive Dollar Interest-Sensitive Gap
• Positive Relative Interest-Sensitive Gap
• Interest Sensitivity Ratio Greater Than

One
McGraw-Hill/Irwin
7-125
Liability Sensitive Bank Has:
• Negative Dollar Interest-Sensitive Gap
• Negative Relative Interest-Sensitive

Gap
• Interest Sensitivity Ratio Less Than

One
McGraw-Hill/Irwin
7-126
Computer-Based Techniques and

Maturity Buckets
McGraw-Hill/Irwin
7-127
Gap Positions and the Effect of

Interest Rate Changes on the Bank
• Asset-Sensitive • Liability-
Bank Sensitive Bank
▫ Interest Rates Rise ▫ Interest Rates Rise
 NIM Rises  NIM Falls
▫ Interest Rates Fall ▫ Interest Rates Fall
 NIM Falls  NIM Rises
McGraw-Hill/Irwin
7-128
Zero Interest-Sensitive Gap
• Dollar Interest-Sensitive Gap is Zero

• Relative Interest-Sensitive Gap is Zero
• Interest Sensitivity Ratio is One
▫ When Interest Rates Change in Either
Direction - NIM is Protected and Will Not
Change
McGraw-Hill/Irwin
7-129
Important Decision Regarding IS Gap
• Management Must Choose the Time Period

Over Which NIM is to be Managed
• Management Must Choose a Target NIM
• To Increase NIM Management Must Either:
▫ Develop Correct Interest Rate Forecast
▫ Reallocate Assets and Liabilities to Increase
Spread
• Management Must Choose Volume of
Interest-Sensitive Assets and Liabilities
McGraw-Hill/Irwin
7-130
NIM Influenced By:
• Changes in Interest Rates Up or Down

• Changes in the Spread Between Assets and
Liabilities
• Changes in the Volume of Interest-Sensitive
Assets and Liabilities
• Changes in the Mix of Assets and Liabilities
McGraw-Hill/Irwin
7-131
Cumulative Gap
The Total Difference in Dollars

Between Those Bank Assets and
Liabilities Which Can be Repriced over
a Designated Time Period
McGraw-Hill/Irwin
7-132
Aggressive Interest-Sensitive Gap

Management
McGraw-Hill/Irwin
7-133
Problems with Interest-Sensitive Gap

Management
• Interest Paid on Liabilities Tend to Move Faster
than Interest Rates Earned on Assets
• Interest Rate Attached to Bank Assets and
Liabilities Do Not Move at the Same Speed as
Market Interest Rates
• Point at Which Some Assets and Liabilities are
Repriced is Not Easy to Identify
• Interest-Sensitive Gap Does Not Consider the
Impact of Changing Interest Rates on Equity
Position
McGraw-Hill/Irwin
7-134
Quick Quiz
• Commerce National Bank reports interest-sensitive assets of
$870 million and interest-sensitive liabilities of $625 million
during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net
interest margin if interest rates rise? If they fall?
• People’s Savings Bank , a thrift institutions, has a cumulative

gap for the coming year of +$135 million, and interest rates
are expected to fall by two and a half percentage points.
Calculate the expected change in net interest income that this
thrift institution might experience. What will occur in net
interest income if interest rates rise by one and a quarter
percentage points?
McGraw-Hill/Irwin
7-135
The Concept of Duration
Duration is the Weighted Average

Maturity of a Promised Stream of
Future Cash Flows
McGraw-Hill/Irwin
7-136
To Calculate the Instrument’s Duration
n n
 (1 YT M) t * CFt
t  (1 YT M) t * CFt
t
D  t 1  t 1
n Current MarketValue or P rice
 (1 YT M)
t 1
CFt
t
McGraw-Hill/Irwin
7-137
Price Sensitivity of a Security
P i
 -D*
P (1  i)
McGraw-Hill/Irwin
7-138
Convexity
The Rate of Change in an Asset’s Price

or Value Varies with the Level of
Interest Rates or Yields
McGraw-Hill/Irwin
7-139
Dollar-Weighted Duration of Asset

Portfolio
n
D A   w i * D Ai
i 1
Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
McGraw-Hill/Irwin
7-140
Dollar-Weighted Duration of a Liability

Portfolio
n
D L   w i * D Li
i 1
Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
McGraw-Hill/Irwin
7-141
Duration Gap
TL
D  DA - DL *
TA
McGraw-Hill/Irwin
7-142
Change in the Value of a Bank’s Net

Worth
 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 
McGraw-Hill/Irwin
7-143
Impact of Changing Interest Rates on a

Bank’s Net Worth
McGraw-Hill/Irwin
7-144
Limitations of Duration Gap Management

• Finding Assets and Liabilities of the Same
Duration Can be Difficult
• Some Assets and Liabilities May Have
Patterns of Cash Flows that are Not Well
Defined
• Customer Prepayments May Distort the
Expected Cash Flows in Duration
• Customer Defaults May Distort the Expected
Cash Flows in Duration
• Convexity Can Cause Problems
McGraw-Hill/Irwin
7-145
Quick Quiz
• What is duration? How is a financial
institution’s duration gap determined?
• What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
• Suppose that a thrift institution has an average
asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds
total assets of $560 million and total liabilities
of $467 million, does it have a significant
leverage-adjusted duration gap? If interest
rates rise, what will happen to the value of its
net worth?
McGraw-Hill/Irwin
Chapter Eight
Risk Management: Financial Futures, Options,

Swaps, and Other Hedging Tools
8-147
Key Topics
• The Use of Derivatives
• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options: Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Regulations and Accounting Rules
• Caps, Floors, and Collars
McGraw-Hill/Irwin
8-148
Derivatives
A Derivative is Any Instrument or

Contract that Derives its Value From
Another Underlying Asset, Instrument,
or Contract, Such as Treasury Bills and
Bonds and Eurodollar Deposits
McGraw-Hill/Irwin
8-149
Managing Interest Rate Risk

• Derivatives Used to Manage Interest Rate
Risk
▫ Financial Futures Contracts
▫ Forward Rate Agreements
▫ Interest Rate Swaps
▫ Options on Interest Rates
 Interest Rate Caps
 Interest Rate Floors
 Interest Rate Collars
McGraw-Hill/Irwin
8-150
Financial Futures Contract

• An Agreement Between a Buyer and a Seller
Which Calls for the Delivery of a Particular
Financial Asset at a Set Price at Some Future
Date
• Futures Markets
▫ The Organized Exchanges Where Futures
Contracts are traded
• Interest Rate Futures
▫ Where the Underlying Asset is an Interest-
Bearing Security
McGraw-Hill/Irwin
8-151
Financial Futures Contracts

IS Gap = IS Assets – IS Liabilities
and
TL
D  DA - DL *
TA
Recall what happens when interest rates rise? Fall?
One of the most popular methods for neutralizing these gap

risks is to buy and sell financial futures contracts
McGraw-Hill/Irwin
8-152
Background on Financial Futures

• Buyers
▫ A buyer of a futures contract is said to be
long futures
▫ Agrees to pay the underlying futures price

or take delivery of the underlying asset
▫ Buyers gain when futures prices rise and

lose when futures prices fall
McGraw-Hill/Irwin
8-153
Background on Financial Futures

• Sellers
▫ A seller of a futures contract is said to be
short futures
▫ Agrees to receive the underlying futures

price or to deliver the underlying asset
▫ Sellers gain when futures prices fall and

lose when futures prices rise
McGraw-Hill/Irwin
8-154
The Purpose of Financial Futures
To Shift the Risk of Interest Rate

Fluctuations from Risk-Averse
Investors to Speculators
McGraw-Hill/Irwin
8-155
The World’s Leading Futures and Option

Exchanges
• Chicago Board of • Euronext.Liffe
Trade (CBT) (Eurex)
• Chicago Board • Sydney Futures
Options Exchange Exchange
• Singapore Exchange • Toronto Futures
Exchange (TFE)
LTD. (SGX)
• South African
• Chicago Mercantile Futures Exchange
Exchange (CME) (SAFEX)
McGraw-Hill/Irwin
8-156
Futures vs. Forward Contracts

▫ Futures Contracts
 Traded on formal exchanges (CBOT, CME, etc.)
 Involve standardized instruments
 Positions require a daily marking to market
▫ Forward Contracts
 Terms are negotiated between parties
 Do not necessarily involve standardized assets
 Require no cash exchange until expiration
 No marking to market
McGraw-Hill/Irwin
8-157
Most Common Financial Futures

Contracts
• U.S. Treasury Bond Futures Contracts

• Three-Month Eurodollar Time Deposit
Futures Contract
• 30-Day Federal Funds Futures Contracts
• One Month LIBOR Futures Contracts
McGraw-Hill/Irwin
8-158
Hedging with Futures Contracts

Avoiding Higher Use a Short Hedge: Sell

Borrowing Costs and Futures Contracts and
Declining Asset Values then Purchase Similar
Contracts Later

Avoiding Lower Than Use a long Hedge: Buy
Expected Yields from Futures Contracts and
Loans and Securities then Sell Similar
Contracts Later
McGraw-Hill/Irwin
8-159
Short Futures Hedge Process

• Today – Contract is Sold Through an
Exchange
• Sometime in the Future – Contract is

Purchased Through the Same Exchange
• Results – The Two Contracts Are Cancelled

Out by the Futures Clearinghouse
• Gain or Loss is the Difference in the Price

Purchased for (At the End) and Price Sold
For (At the Beginning)
McGraw-Hill/Irwin
8-160
Long Futures Hedge Process

• Today – Contract is Purchased Through an
Exchange
• Sometime in the Future – Contract is sold

Through the Same Exchange
• Results – The Two Contracts are Cancelled

by the Clearinghouse
• Gain or Loss is the Difference in the Price

Purchase For (At the Beginning) and the
Price Sold For (At the End)
McGraw-Hill/Irwin
8-161
Basis Risk
The basis is the cash price of an asset minus
the corresponding futures price for the
same asset at a point in time
▫ For financial futures, the basis can be calculated as
the futures rate minus the spot rate
▫ It may be positive or negative, depending on whether
futures rates are above or below spot rates
▫ May swing widely in value far in advance of contract
expiration
Basis=Cash-market price (or interest rate) –

futures market price (or interest rate)
McGraw-Hill/Irwin
8-162
Realized Return from Combining Cash

and Futures Market Trading
= Return Earned in the Cash Market
+/- Profit or Loss from Futures Trading
- Closing Basis Between Cash and Futures

Market
- Opening Basis Between Cash and Futures

Market
McGraw-Hill/Irwin
8-163
Change in the Market Value of the

Futures Contract
McGraw-Hill/Irwin
8-164
Change in the Market Value of the

Futures Contract
i
Ft  F0  -D  F0  N 
McGraw-Hill/Irwin
(1  i)
8-165
Number of Futures Contracts

Needed
TL
(D A - D L * ) * TA
 TA
D F * Price of the Futures Contract
McGraw-Hill/Irwin
8-166
Quick Quiz
• What are financial futures contracts? Which
financial institutions use futures and other
derivatives for risk management?
• How can financial futures help financial

service firms deal with interest rate risk?
• What futures transactions would most likely

be used in a period of rising interest rates?
Falling interest rates?
McGraw-Hill/Irwin
8-167
Interest Rate Option
It Grants the Holder of the Option the

Right but Not the Obligation to Buy or
Sell Specific Financial Instruments at
an Agreed Upon Price.
McGraw-Hill/Irwin
8-168
Types of Options
• Put Option
▫ Gives the Holder of the Option the
Right to Sell the Financial Instrument
at a Set Price
• Call Option
▫ Gives the Holder of the Option the
Right to Purchase the Financial
Instrument at a Set Price
McGraw-Hill/Irwin
8-169
Most Common Option Contracts

Used By Banks
• U.S. Treasury Bond Futures Options
• Eurodollar Futures Option
McGraw-Hill/Irwin
8-170
Principal Uses of Option Contracts

• 1. Protecting a security portfolio through the use of put
options to insulate against falling security prices (rising
interest rates); however, there is no delivery obligation
under an option contract so the user can benefit from
keeping his or her securities if interest rates fall and
security prices rise
• 2. Hedging against positive or negative gaps between

interest-sensitive assets and interest- sensitive
liabilities; for example, put options can be used to
offset losses from a negative gap when interest rates
rise, while call options can be used to offset a positive
gap when interest rates fall.
McGraw-Hill/Irwin
8-171
McGraw-Hill/Irwin
8-172
McGraw-Hill/Irwin
8-173
Speculation vs. Hedging

• With financial futures, risk often cannot be
eliminated, only reduced.
▫ Traders normally assume basis risk in that
the basis might change adversely between
the time the hedge is initiated and closed
• Perfect Hedge
▫ The gains (losses) from the futures position
perfectly offset the losses (gains) on the spot
position at each price
McGraw-Hill/Irwin
8-174
Federal Funds Options and Futures
• Represents the Consensus Opinion Of the

Likely Future Course of Market Interest
Rates
• Public Trading for Futures Contract Began
at the CBOT in 1988
• Public Trading on Options Contracts Began
in 2003
McGraw-Hill/Irwin
8-175
Regulations For Options and Future

Contracts
• OCC – Risk Management of Financial

Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities
McGraw-Hill/Irwin
8-176
Interest Rate Swap
A Contract Between Two Parties to

Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk
McGraw-Hill/Irwin
8-177
Interest –Rate Swap
McGraw-Hill/Irwin
8-178
Quality Swap
• Borrower with Lower Credit Rating

Pays Fixed Payments of Borrower with
Higher Credit Rating
• Borrower with Higher Credit Rating
Pays Short-Term Floating Rate
Payments of Borrower with Lower
Credit Rating
McGraw-Hill/Irwin
8-179
Further…
• Firms with a negative GAP can reduce risk
by making a fixed-rate interest payment in
exchange for a floating-rate interest receipt
• Firms with a positive GAP take the opposite

position, by making floating-interest
payments in exchange for a fixed-rate
receipt
McGraw-Hill/Irwin
8-180
Risks of Interest Rate Swaps

• Substantial Brokerage Fees
• Credit Risk
▫ The counterparty may default on the exchange of
the interest payments
▫ Only the interest payment exchange is at risk,
not the principal
• Basis Risk
▫ A swap’s reference interest rates are not the
same as those attached to all the assets and
liabilities (LIBOR, bond rates, etc.), so rates do
not change exactly the same -> some risk
remains
• Interest Rate Risk
McGraw-Hill/Irwin
8-181
Netting
The Swap Parties Only Swap the Net

Difference Between the Interest
Payments. This Reduces the Potential
Damage if One Party Defaults on its
Obligation
McGraw-Hill/Irwin
8-182
Currency Swap
An Agreement Between Two Parties,

Each Owing Funds to Other
Contractors Denominated in Different
Currencies, to Exchange the Needed
Currencies with Each Other and Honor
Their Respective Contracts.
McGraw-Hill/Irwin
8-183
Interest Rate Cap
Protects the Holder from Rising

Interest Rates. For an Up Front Fee
Borrowers are Assured Their Loan Rate
Will Not Rise Above the Cap Rate
McGraw-Hill/Irwin
8-184
Interest Rate Floor
A Contract Setting the Lowest Interest

Rate a Borrower is Allowed to Pay on a
Flexible-Rate Loan
McGraw-Hill/Irwin
8-185
Interest Rate Collar
A Contract Setting the Maximum and

Minimum Interest Rates That May Be
Assessed on a Flexible-Rate Loan. It
Combines an Interest Rate Cap and
Floor into One Contract.
McGraw-Hill/Irwin
8-186
Quick Quiz
• Explain what is involved in a put option?

• What is a call option?
• Suppose market interest rates were
expected to rise. What type of option would
normally be used?
• If rates were expected to fall, what type of
option would a financial institution’s
manager be likely to employ?
McGraw-Hill/Irwin
Chapter Nine
Risk Management: Asset-Backed

Securities, Loan Sales, Credit Standbys,
and Credit Derivatives
9-188
Key Topics
• The Securitization Process
• Securitization’s Impact and Risks
• Sales of Loans: Nature and Risks
• Standby Credits: Pricing and Risks
• Credit Derivatives and CDOs
• Benefits and Risks of Credit Derivatives

McGraw-Hill/Irwin
9-189
Securitization of Loans
The Pooling of a Group of Similar

Loans and Issuing Securities Against
the Pool Whose Return Depends on
the Stream of Interest and Principal
Payments Generated by the Loans
McGraw-Hill/Irwin
9-190
The Heart of the

Securitization Process
McGraw-Hill/Irwin
9-191
• Originator – Bank or Lender Who Makes the
Loan
• Issuer – Special Purpose Entity That Issues
the Securities
• Credit Rating Agency – Rates the Securities
• Security Underwriter or Investment Banker
Helps Issue Securities
• Trustee – Makes Sure Issuer Fulfills All
Their Obligations
• Servicer- Collects Payments on the
Securitized Loans
McGraw-Hill/Irwin
9-192
Key Players in the Securitization Process
McGraw-Hill/Irwin
9-193
Advantages of Securitization
• Diversifies a Bank’s Credit Risk Exposure
• Creates Liquid Assets Out of Illiquid Assets
• Transforms These Assets into New Sources
of Capital
• Allows the Bank to Hold a More
Geographically Diversified Loan Portfolio
• Allows the Bank to Better Manage Interest
Rate Risk
• Allows the Bank to Generate Fee Income
McGraw-Hill/Irwin
9-194
Problems with Securitization

• May Not Reduce a Bank’s Capital Requirements
• Prepayment Risk
• May Increase Competition for the Best Quality
Loans
• May Increase Competition for Deposits
• Credit Crisis of 2007-2009 showed that the
“bankruptcy remote” SPE arrangements can get
into trouble if the underlying loans go bad
• GSEs: Ethical Controversies Around Fannie Mae
and Freddie Mac
McGraw-Hill/Irwin
9-195
Promised Fees and Payments on

Securitized Loans
• Coupon Rate Promised to Investors Who Buy
Securities
• Default Rate on the Pooled Loans
• Fees to Compensate for Servicing Loans
• Fees Paid to Advise on Setting Up
• Fees Paid for Providing Liquidity
Enhancement
• Residual Income For Security Seller, Trust or
Credit Enhancer
McGraw-Hill/Irwin
9-196
Types of Securitized Assets

• Residential Mortgages – the beginnings of
securitization
▫ The role of GSEs (GNMA, FNMA, FHLMC)
▫ Riskier CMOs
• Home Equity Loans
• Automobile Loans (CARs)
• Commercial Mortgages
• Small Business Administration Loans
• Mobile Home Loans
• Credit Card Receivables
• Truck Leases
• Computer Leases
McGraw-Hill/Irwin
9-197
Regulators’ Concerns About The Soundness and

Safety of Lenders and Financial System
• Risk of Having to Come Up with Large Amounts of Liquidity
Quickly to Make Payments To Investors Holding Securities
• Risk of Agreeing to Serve as Underwriter for Securities that
Cannot be Sold
• Risk of Acting as Credit Enhancer and Underestimating
Need for Loan Reserves
• Risk that Unqualified Trustees Will Fail to Protect Investors
• Risk of Loan Servicers Being Unable to Satisfactorily
Monitor Loan Performance and Collect Monies Owed
• In light of the credit crisis, also focus on the impact of
securitization on the remaining portfolio of loans that are
not securitized
McGraw-Hill/Irwin
9-198
Quick Quiz
• What does securitization of assets mean?
• What kinds of assets are most amenable to

the securitization process?
• What advantages does securitization offer

lending institutions?
• What are the most important risks

associated with the securitization process
(from the lending institution and the
regulators’ perspectives)?
McGraw-Hill/Irwin
9-199
Loan Sales
Selling Loan Contracts Held by an

Institution in Order to Raise New Cash
McGraw-Hill/Irwin
9-200
The Impact of Loan Sales
McGraw-Hill/Irwin
9-201
Servicing Rights
The Selling Bank Can Generate Fees

for Agreeing to Keep Records, Collect
Monies Owed and Help Enforce the
Terms of a Group of Loan Contracts
and Passing the Proceeds on to the
Loan Buyers
McGraw-Hill/Irwin
9-202
Types of Loan Sales

• Participation Loans
▫ Where an Outside Party Purchases a Loan. They
Generally Have No Influence Over the Loan Terms
• Assignments
▫ Ownership of the Loan is Transferred to the
Buyer of the Loan. The Buyer Has a Direct Claim
Against the Borrower.
• Loan Strip
▫ Short-Dated Pieces of Longer Term Loans,
Maturing in a Few Days or Weeks
McGraw-Hill/Irwin
9-203
Reasons Behind Loan Sales

• Way to Rid the Bank of Lower-Yielding
Assets to Make Room for Higher-Yielding
Assets when Interest Rates Rise
• Way to Increase Marketability and Liquidity
of Assets
• Way to Eliminate Credit and Interest Rate
Risk
• Way to Generate Fee Income
• Purchasing Bank can Diversify Loan Portfolio
and Reduce Risk
McGraw-Hill/Irwin
9-204
Risks In Loan Sales

• Best Quality Loans are the Easiest to Sell
Which May Increase Volatility of Earnings for
the Bank Which Sells the Loans
• Loan Purchased From Another Bank Can

Turn Bad Just as Easily As One From Their
Own Bank
• Loan Sales are Cyclical
McGraw-Hill/Irwin
9-205
Standby Letters of Credit (SLCs)

• Financial Instrument that Enhances the
Credit Standing of a Borrower by Providing
Guarantees of Performance or Insures
Against Default in Return for Payment of a
Fee. It is a Contingent Obligation
▫ Performance Guarantees – Guarantees a

Project Will be Completed On Time
▫ Default Guarantees – Financial Institution
Pledges Repayment of Defaulted Notes When
Borrowers Cannot Pay
McGraw-Hill/Irwin
9-206
Advantages of SLCs
• Letters of Credit Earn a Fee for Providing

the Service (0.5 to 1 percent of the amount
of credit involved)
• They Aid a Customer Who Can Borrow More
Cheaply When There is a Guarantee
• Such Guarantees Can be Issued at Relatively
Low Cost
• Probability is Usually Low that an Issuer of
SLC Will Ever Be Called On to Pay
McGraw-Hill/Irwin
9-207
Reasons for Growth of SLCs
• Rapid Growth of Direct Financing Worldwide
• Risk of Economic Fluctuations has led to

Demand for Risk-Reducing Devices
• Opportunity SLCs Offer Lenders to Use

Their Credit Evaluation Skills to Earn Fee
Income Without the Immediate Commitment
of Funds
• The Relatively Low Cost of Issuing SLCs

McGraw-Hill/Irwin
9-208
Structure of SLCs
Three Essential Elements:
• Commitment From Issuer
• An Account Party – For Whom the

Letter is Issued
• A Beneficiary – Investor Concerned

About Funds Committed to Account
Party
McGraw-Hill/Irwin
9-209
Sources of Risk with SLCs

• Default Risk of Issuing Bank
• Beneficiary Must Meet All Conditions

of Letter to Receive Payment
• Bankruptcy Laws Can Cause Problems

for SLCs
• Issuer Faces Substantial Interest Rate

and Liquidity Risks
McGraw-Hill/Irwin
9-210
Ways to Reduce Risk Exposure of SLCs
• Frequently Renegotiating the Terms of Any

Loans Extended to Customers
• Diversifying SLCs Issued by Region and

Industry
• Selling Participations in Standbys in Order

to Share Risk
McGraw-Hill/Irwin
9-211
Regulatory Concerns About SLCs
• Bank Examiners are Working to Keep Risk

Exposure Under Control Leading to New
Regulatory Rules:
▫ Banks Must Apply the Same Credit Standards
to SLCs as for Loans
▫ Banks Must Count SLCs as Loans When
Assessing Risk Exposure to a Single
Customer
▫ Banks Must Post Capital Behind Most SLCs
McGraw-Hill/Irwin
9-212
Credit Derivatives
• Over-the-Counter Financial Agreements
Offering Protection to a Designated
Beneficiary in Case of Default on a Loan,
bond, or Other Debt Instruments
• Was One of the Fastest-Growing

Markets, but the Credit Crisis Uncovered
Problems with Recordkeeping and
Possible Increasing Risk Exposure
McGraw-Hill/Irwin
9-213
Types of Credit Derivatives

• Credit Swaps
• Credit Options
• Credit Default Swaps
• Credit Linked Notes
• Collateralized Debt Obligations
McGraw-Hill/Irwin
9-214
Credit Swaps
• Two Lenders Agree to Swap a Portion of
Their Customer’s Loan Payments
• Can Help Each Lender Further Spread Out
Their Risk
• Variation is a Total Return Swap Where the
Dealer Guarantees Parties a Specific Rate of
Return
McGraw-Hill/Irwin
9-215
Credit Options
Guards Against Losses in Value of a Credit
Asset or Helps Offset Higher Borrowing
Costs Due to Changes in Credit Ratings of
the Borrower
McGraw-Hill/Irwin
9-216
Credit Default Swaps

Aimed at Lenders Able to Handle
Comparatively Limited Declines in Value But
Who Want Insurance Against Serious Losses
McGraw-Hill/Irwin
9-217
Credit Linked Notes
• Fuses Together a Normal Debt Instrument

with a Credit Option Contract to Give
Borrower Greater Payment Flexibility
McGraw-Hill/Irwin
9-218
Collateralized Debt Obligations

• Contain Pools of High-Yield Corporate Bonds,
Stocks or Other Financial Instruments
Contributed by Businesses Interested In
Strengthening Their Balance Sheets and Raising
New Funds. Notes of Varying Grades are Sold
to Investors Seeing Income From Pooled Assets
• The Credit and Liquidity Crisis of 2007-2009
has Exposed
▫ The Complexity of These Instruments
▫ Questionable Credit Ratings Assignments
▫ Huge Write-Downs of CDO Values Worldwide
McGraw-Hill/Irwin
9-219
Risks of Credit Derivatives

• Partners in Swap or Option Contract May Fail to
Perform
• Smaller Volume – Markets are Thinner and More
Volatile
• Legal Issues
• Regulatory Concerns
• Lessons of Credit Crisis:
▫ Securitized Assets and Credit Swaps are Complex
Financial Instruments that are Difficult to Correctly
Value and Measure in Terms of Risk Exposures
▫ Operate in Cyclically Sensitive Markets
▫ Contagion Effect Cannot be Stopped without Active
Government Intervention
McGraw-Hill/Irwin
Chapter Eleven
Liquidity and Reserves Management:

Strategies and Policies
11-221
Liquidity
• The Availability of Cash in the Amount and

at the Time Needed at a Reasonable Cost
• The size and volatility of cash requirements

affect the liquidity position of the bank
▫ Examples of transaction that affect the bank’s
cash balance and liquidity position: Deposits
and withdrawals; loan disbursements and
loan payments
McGraw-Hill/Irwin
11-222
Supplies of Liquid Funds
• Incoming Customer Deposits
• Revenues from the Sale of Nondeposit

Services
• Customer Loan Repayments
• Sales of Bank Assets
• Borrowings from the Money Market
McGraw-Hill/Irwin
11-223
Demands for Liquidity

• Customer Deposit Withdrawals
• Credit Requests from Quality Loan

Customers
• Repayment of Nondeposit Borrowings
• Operating Expenses and Taxes
• Payment of Stockholder Dividends

McGraw-Hill/Irwin
11-224
McGraw-Hill/Irwin
11-225
A Financial Firm’s Net Liquidity

Position
L = Supplies of Liquid Funds

- Demands for Liquidity
McGraw-Hill/Irwin
11-226
Quick Quiz: Comprehensive Problem

Suppose that a bank faces the following cash inflows and outflows
during the coming week:
a) deposit withdrawals are expected to total $33 million;
b) customer loan repayments are expected to amount to $108
million;
c) Operating expenses demanding cash payment will probably
approach $51 million;
d) Acceptable new loan requests should reach $294 million;
e) Sales of bank assets are projected to be $18 million;
f) New deposits should total $670 million;
g) Borrowings from the money market are expected to be about $43
million;
h) Nondeposit service fees should amount to $27 million;
i) Previous bank borrowings totaling $23 million are scheduled to be
repaid; and
j) A dividend payment to bank stockholders of $140 million is
scheduled.
What is this bank’s projected net liquidity position for the coming
McGraw-Hill/Irwin
week?
11-227
Essence of Liquidity Management

• Rarely are the Demands for Liquidity Equal
to the Supply of Liquidity at Any Particular
Moment. The Financial Firm Must
Continually Deal with Either a Liquidity
Deficit or Surplus
• There is a Trade-Off Between Liquidity and
Profitability. The More Resources Tied Up
in Readiness to Meet Demands for Liquidity,
the Lower is the Financial Firm’s Expected
Profitability.
McGraw-Hill/Irwin
11-228
Why Banks and Their Competitors

Face Significant Liquidity Problems
• Imbalances Between Maturity Dates of Their Assets and
Liabilities
• High Proportion of Liabilities (especially demand

deposits and money market borrowings) Subject to
Immediate Repayment
• Sensitivity to Changes in Interest Rates

▫ May affect customer demand for deposits
▫ May affect customer demand for loans
• Central Role in the Payment Process, Reputation and

Public Confidence in the System
McGraw-Hill/Irwin
11-229
Strategies for Liquidity Managers

1. Think about what is a liquid asset?
2. Identify strategies for liquidity
management.
• Asset Liquidity Management or Asset

Conversion Strategy
• Borrowed Liquidity or Liability

Management Strategy
• Balanced Liquidity Strategy

McGraw-Hill/Irwin
11-230
Asset Liquidity Management
This Strategy Calls for Storing

Liquidity in the Form of Liquid Assets
(T-bills, fed funds loans, CDs, etc.)
and Selling Them When Liquidity is
Needed
McGraw-Hill/Irwin
11-231
Liquid Asset
• Must Have a Ready Market So it Can Be

Converted to Cash Quickly
• Must Have a Reasonably Stable Price
• Must Be Reversible So an Investor Can

Recover Original Investment with Little
Risk
McGraw-Hill/Irwin
11-232
Options for Storing Liquidity

• Treasury Bills • Municipal Bonds and
• Fed Funds Sold to Notes
Other Banks • Federal Agency
• Purchasing Securities Securities
for Resale (Repos) • Negotiable Certificates
• Deposits with of Deposits
Correspondent Banks • Eurocurrency Loans
McGraw-Hill/Irwin
11-233
Asset Liquidity Management is Not

Costless and Include Opportunity Cost:
• Loss of Future Earnings on Assets That Must

Be Sold
• Transaction Costs (Commissions) on Assets
That Must Be Sold
• Potential Capital Losses If Interest Rates are
Rising
• May Weaken Appearance of Balance Sheet
• Liquid Assets Generally Have Low Returns
McGraw-Hill/Irwin
11-234
Borrowed Liquidity (Liability)

Management
This Strategy Calls for the Bank to

Purchase or Borrow from the
Money Market To Cover All of Its
Liquidity Needs
McGraw-Hill/Irwin
11-235
Sources of Borrowed Funds
• Federal Funds Purchased

• Selling Securities for Repurchase (Repos)
• Issuing Large CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home
Loan Bank
• Borrowing Reserves from the Discount
Window of the Federal Reserve
McGraw-Hill/Irwin
11-236
Borrowed Liquidity (Liability)

Management Strategy
Advantages Disadvantages
• Borrow Only When There • Highest Expected Return

is a Need for Funds But Carries the Highest
• Volume and Composition Risk Due to Volatility of
of the Investment Interest Rates and Possible
Portfolio Can Remain Rapid Changes in Credit
Unchanged Availability
• The Institution Can • Borrowing Cost is Always
Control Interest Rates in Uncertain-> Uncertain
Order to Borrow Funds Earnings
(raise offer rates when • Borrowing Needs Can Be
needs requisite amounts Interpreted as a Signal of
of funds)
McGraw-Hill/Irwin Financial Difficulties
11-237
Balanced Liquidity Management

Strategy
The Combined Use of Liquid Asset

Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet Liquidity
Needs
McGraw-Hill/Irwin
11-238
Guidelines for Liquidity Managers

• They Should Keep Track of All Fund-
Using and Fund-Raising Departments
• They Should Know in Advance
Withdrawals by the Biggest Credit or
Deposit Customers
• Their Priorities and Objectives for
Liquidity Management Should be Clear
• Liquidity Needs Must be Evaluated on a
Continuing Basis
McGraw-Hill/Irwin
11-239
Methods for Estimating Liquidity

Needs
• Sources and Uses of Funds Approach
• Structure of Funds Approach
• Liquidity Indicator Approach
• Signals from the Marketplace
McGraw-Hill/Irwin
11-240
Sources and Uses of Funds

• Loans and Deposits Must Be Forecast for a
Given Liquidity Planning Period
• The Estimated Change in Loans and
Deposits Must Be Calculated for the Same
Planning Period
• The Liquidity Manager Must Estimate the
Bank’s Net Liquid Funds By Comparing the
Estimated Change in Loans to the Estimated
Change in Deposits
McGraw-Hill/Irwin
11-241
McGraw-Hill/Irwin
11-242
Structure of Funds Approach

• A Bank’s Deposits and Other Sources of
Funds Divided Into Categories. For
Example:
▫ ‘Hot Money’ Liabilities (volatile liabilities)
▫ Vulnerable Funds
▫ Stable Funds (core deposits or core liabilities)
• Liquidity Manager Set Aside Liquid Funds
According to Some Operating Rule
McGraw-Hill/Irwin
11-243
Customer Relationship Doctrine
Management Should Strive to Meet All

Good Loans that Walk in the Door in
Order to Build Lasting Customer
Relationships
McGraw-Hill/Irwin
11-244
Liquidity Indicator Approach

(Based on Experience and Industry Averages)
• Cash Position Indicator • Hot Money Ratio
• Liquid Security Indicator • Deposit Brokerage Index
• Net Federal Funds Position • Core Deposit Ratio
• Capacity Ratio • Deposit Composition Ratio
• Pledged Securities Ratio • Loan Commitment Ratio
McGraw-Hill/Irwin
11-245
The Ultimate Standard: Market

Signals of Liquidity Management
• Public Confidence
• Stock Price Behavior
• Risk Premiums on CDs
• Loss Sales of Assets
• Meeting Commitments to Creditors
• Borrowings from the Central Bank

McGraw-Hill/Irwin
11-246
Legal Reserves
• Assets That a Central Bank Requires

Depository Institutions to Hold as a
Reserve Behind Their Deposits or
Other Liabilities
• Only 2 Kinds of Assets Can Be Used

for This Purpose: 1) Cash in the Vault;
2) Deposits Held in a Reserve Account
With the Regional Fed.
McGraw-Hill/Irwin
11-247
U.S. Legal Reserve Requirements

• In 2007-2008, first $9.3 Million have 0 Legal
Reserves
• 3 Percent of End-of-the-Day Daily Average for
a Two Week Period For Transaction Accounts
Up To $43.9 Million ($43.9 million is known as
the reserve tranche and changes every year)
• 10 Percent of End-of-the-Day Daily Average
for a Two Week Period For Transaction
Accounts For Amounts Over $43.9 Million
• Transaction Accounts Include Checking
Accounts, NOW Accounts and Other Deposits
Used to Make Payments
• The $43.9 Million Amount is Adjusted Annually
• The Money Position Manager Oversees the
Institution’s Legal Reserve Account
McGraw-Hill/Irwin
11-248
Calculating Required Reserves
Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserve’s discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
McGraw-Hill/Irwin
11-249
Factors Influencing the Money Position
McGraw-Hill/Irwin
11-250
Sweep Account
• Volume of Legal Reserves Held at the Fed
Has Declined in Recent Years Largely Due to
Sweep Accounts
• A Contractual Account Between Bank and

Customer that Permits the Bank to Move
Funds Out of a Customer’s Checking
Account Overnight in Order to Generate
Higher Returns for the Customer and Lower
Reserve Requirements for the Bank
▫ Retail Sweep
▫ Business Sweep
McGraw-Hill/Irwin
11-251
Other Factors to Influence Legal

Reserves
• Use of Fed Funds Market
▫ The cheapest source
▫ But very volatile
▫ Managers rely on the Fed funds target rate (the
most volatile on the settlement date)
• Other Options
▫ Sell liquid securities
▫ Draw upon excess correspondent balances
▫ Enter into repurchase agreements for temporary
borrowings
▫ Sell new time deposits
▫ And borrow in the Eurocurrency market
McGraw-Hill/Irwin
11-252
Factors in Choosing Among Different

Sources of Reserves
• Immediacy of Bank’s Needs
• Duration of Bank’s Needs
• Bank’s Access to Market for Liquid Funds
• Relative Costs and Risks of Alternatives
• Interest Rate Outlook
• Outlook for Central Bank Monetary Policy
• Regulations Applicable for Liquidity Sources

McGraw-Hill/Irwin
11-253
Quick Quiz
• What are the principal differences among asset
liquidity management, liability management,
and balanced liquidity management?
• What guidelines should management keep in
mind when it manages a financial firm’s
liquidity position?
• What is money position management?
• What is the principal goal of money position
management?
• What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account?
McGraw-Hill/Irwin
Chapter Twelve
Managing and Pricing Deposit

Services
12-255
Key Topics
• Types of Deposit Accounts Offered
• The Changing Mix of Deposits and Deposit Costs
• Pricing Deposit Services and Deposit Interest Rates
• Conditional Deposit Pricing
• Rules for Deposit Insurance Coverage
• Disclosure of Deposit Terms
• Lifeline Banking
McGraw-Hill/Irwin
12-256
Key Issues Depository Institutions Are

Faced With:
1. Where can funds be raised at lowest
possible cost?
2. How can management ensure that there

are enough deposits to support lending
and other services the public demands?
McGraw-Hill/Irwin
12-257
Recent Trends
• Pricing Schedules and Competitive

Maneuverings of Other Financial Institutions
• Competitors: Mutual Funds, Credit Unions,
Cash Management Accounts at Brokerage
Firms and Insurance Companies, and
Interest-Bearing Investment Accounts
Offered by Securities Firms
• An Important Executive Position of the Chief
Deposit Officer
McGraw-Hill/Irwin
12-258
Types of Deposit Accounts

• Transaction (Payment or Demand) Deposits
▫ Making Payment on Behalf of Customers
▫ One of The Oldest Services
▫ Provider is Required to Honor Any
Withdrawals Immediately
• Nontransaction (Savings or Thrift) Deposits
▫ Longer-Term
▫ Higher Interest Rates Than Transaction
Deposits
▫ Generally Less Costly to Process and Manage
McGraw-Hill/Irwin
12-259
Transaction Deposit
An Account Used Primarily to Make

Payments for Purchases of Goods and
Services
McGraw-Hill/Irwin
12-260
Types of Transaction Deposits

• Noninterest-Bearing Demand Deposits
▫ Interest Was Prohibited by Glass-Steagall Act
▫ One of the Most Volatile and Unpredictable
Sources of Funds
▫ Most Deposits are Held by Business Firms
• Interest-Bearing Demand Deposits
▫ Negotiable Orders of Withdrawal (NOW)-
hybrid savings instrument
▫ Money Market Deposit Account (MMDA) and
Super NOW due to Garn-St Germain
Depository Institution Act of 1982
McGraw-Hill/Irwin
12-261
Nontransaction (Savings or Thrift)

Deposit
An Account Whose Primary Purpose is

to Encourage the Bank Customer to
Save Rather than Make Payments
McGraw-Hill/Irwin
12-262
Types of Savings or Thrift Deposits

• Passbook Savings Account
• Statement Savings Deposit
• Time Deposit (CD)
• Individual Retirement Account (IRA) -
The Economic Recovery Tax Act of1981
• Keogh Deposit – have tax benefits
• Roth IRA – The Tax Relief Act of 1997
Allows Non-Tax-Deductible
Contributions
• Default Option Retirement Plans – The
Pension Protection Act of 2006
McGraw-Hill/Irwin
12-263
Popular Types of CDs
• Bump-Up CD – Allows a Depositor to Switch

to a Higher Interest Rate if Market Rates
Rise
• Step-Up CD – Permits Periodic Upward
Adjustments in the Promised Interest Rate
• Liquid CD – Permits the Depositor to
Withdraw Some or All of Their Funds
Without a Withdrawal Penalty
McGraw-Hill/Irwin
12-264
Interest Rates on Deposits Depend

On:
• The Maturity of the Deposit
• The Size of the Offering Institution
• The Risk of the Offering Institution
• Marketing Philosophy and Goals of the

Offering Institution
McGraw-Hill/Irwin
12-265
The Changing Composition of Deposits in the US
McGraw-Hill/Irwin
12-266
Core Deposits
A Stable Base of Funds that is Not

Highly Sensitive to Movements in
Market Interest Rates (Low Interest-
Rate Elasticity) and Which Tend to
Remain with the Bank
McGraw-Hill/Irwin
12-267
Check 21 and Substitute Checks

• Effective October 28,2004 – Permits
Depository Institutions to Electronically
Transfer Check Images
• The Images are Called Substitute Checks
and is a Legal Copy of the Check
• Protects Depositors Against Loss
• Benefits Institutions by Reducing the Cost
of Check Clearing
• Substitute Checks Can Be Sent Electronically
Instead of Sending Bundles of Checks
• More Information:
http://www.federalreserve.gov/
McGraw-Hill/Irwin
12-268
FDIC Insurance Coverage

• Banks Insured Through Bank Insurance Fund
(BIF)
• Savings and Loans Insured Through Savings
Association Insurance Fund (SAIF)
• Covers Only Those Deposits Payable in the
U.S.
• Many Types of Accounts are Covered Up To
$100,000 (increased to $250,000 until year-
end 2009 by the Emergency Economic
Stabilization Act of 2008) for Each Account
Holder within the Same Bank (Even if Different
Branches)
• Deposits Placed in Separate Institutions are
Insured Separately © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
12-269
Truth in Savings Act

• Consumers Must be Informed of the
Deposit Terms Before They a New Account
• Depository Institutions Must Disclose:
▫ Minimum Balance to Open
▫ Minimum to Avoid Fees
▫ How the Balance is Figured
▫ When Interest Begins to Accrue
▫ Penalties for Early Withdrawal
▫ Options at Maturity
▫ And the APY
McGraw-Hill/Irwin
12-270
Pricing Deposit-Related Services
• The Glass-Steagall Act of 1933 – Federal

Limits on Interest Rates Paid on Deposits –
why?
• Nonprice Competition
• The Depository Institutions Deregulation
Act of 1980
▫ Cost-Plus Pricing
▫ Marginal Cost of Deposits
▫ Conditional Pricing
▫ Relationship Pricing
McGraw-Hill/Irwin
12-271
Cost Plus Profit Deposit Pricing
Estimating
Unit Price Operating Planned
Overhead
Charged the Expense Profit from
Expense
Customer = Per Unit of + + Each
Allocated to
for Each Deposit Service Unit
the Deposit
Service Service Sold
Function
McGraw-Hill/Irwin
12-272
The Marginal Cost Approach:

Historical Average Cost Approach
Determines the Bank’s Const of Funds by

Looking at the Past. It Looks at What Funds
the Bank Has Raised to Date and What those
Funds Have Cost
McGraw-Hill/Irwin
12-273
Pooled Funds Approach
Determine the Bank’s Cost of Funds

by Looking at the Future. What
minimum Rate of Return is the Bank
Going to Have to Earn on Any Future
Loans and Securities to Cover the Cost
of all New Funds Raised?
McGraw-Hill/Irwin
12-274
Using Marginal Cost to Set Interest

Rates on Deposits
Many Financial Analysts Would Argue

That the Added Cost (Not Weighted
Average Cost) of Bringing New Funds
into the Bank Should Be Used to Price
Deposits.
McGraw-Hill/Irwin
12-275
Market Penetration Deposit Pricing
The Method of Selling Deposits That

Usually Sets Low Prices and Fees
Initially to Encourage Customers to
Open an Account and Then Raises
Prices and Fees Later On.
McGraw-Hill/Irwin
12-276
Conditional Pricing
• Schedule of Fees were Low If Customer
Stayed Above Some Minimum Balance -
Fees Conditional On How the Account Was
Used
• Conditional Pricing Based On One or More
Of the Following Factors
▫ The Number of Transactions Passing Through the
Account
▫ The Average Balance Held in the Account During
the Period
▫ The Maturity of the Deposit
McGraw-Hill/Irwin
12-277
Upscale Target Pricing

Bank Aggressively Goes After High-
Balance, Low-Activity Accounts. Bank
Uses Carefully Designed Advertising to
Target Established Business Owners
and Managers and Other High Income
Households.
McGraw-Hill/Irwin
12-278
Relationship Pricing
The Bank Prices Deposits According to

the Number of Services Purchased or
Used. The Customer May Be Granted
Lower Fees or Have Some Fees Waived
If Two or More Services are Used.
McGraw-Hill/Irwin
12-279
Basic or Lifeline Banking
Some People Feel That All Individuals

Are Entitled to a Minimum Level of
Financial Services No Matter Their
Income Level
McGraw-Hill/Irwin
12-280
Quick Quiz
• What are the major types of deposit plans offered
today?
• What are core deposits, and why are they so
important?
• How has the composition of deposits changed in
recent years?
• A bank determines from an analysis of its cost-
accounting figures that for each $500 minimum-
balance checking account it sells, account
processing and other operating costs will average
$4.87 per month and overhead expenses will urn
an average of $1.21 per month. The bank hopes to
achieve a profit margin over these particular costs
of 10 percent of total monthly costs. What monthly
fee should it charge a customer who opens one of
these checking accounts?
McGraw-Hill/Irwin
12-281
Quick Quiz (cont.)
• Suppose that a customer holds a savings

deposit in a savings bank for a year. The
balance in the account stood at $2000 for
180 days and $100 for the remaining days
in the year. If the savings bank paid this
depositor $8.50 in interest earnings for the
year, what APY did this customer receive?
(Use the formula required by the Truth in
Savings Act)
McGraw-Hill/Irwin
Chapter Fifteen
The Management of Capital
15-283
Key Topics
• The Many Tasks of Capital
• Capital and Risk Exposures
• Types of Capital In Use
• Capital as the Centerpiece of Regulation
• Basel I and Basel II
• Planning to Meet Capital Needs

McGraw-Hill/Irwin
15-284
Tasks Performed By Capital

• Provides a Cushion Against Risk of
Failure
• Provides Funds to Help Institutions Get
Started
• Promotes Public Confidence (credit crisis
2007-2009 showed importance)
• Provides Funds for Growth
• Regulator of Growth
• Role in Growth of Bank Mergers
• Regulatory Tool to Limit Risk Exposure
• Protects the Government’s Deposit
Insurance System
McGraw-Hill/Irwin
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Key Risks in Financial Institutions

Management
• Credit Risk
▫ Probability of default on any promised payments of
interest or principal or both
• Liquidity Risk
▫ Probability of being unable to raise cash when needed
at reasonable cost
• Interest Rate Risk
▫ Probability that changes in interest rates will
adversely affect the value of net worth
• Operational Risk
▫ Probability of adverse affect of earnings due to
failures in computer systems, management errors,
etc.
• Exchange Risk
▫ Probability of loss due to fluctuating currency prices
• Crime Risk
▫ Due to embezzlement, robbery,
McGraw-Hill/Irwin fraud,
© 2008 The McGraw-Hill
identity
Companies, theft
Inc., All Rights Reserved.
15-286
Defenses Against Risk

• Quality Management
• Diversification
▫ Geographic
▫ Portfolio
• Deposit Insurance (increased from
$100K to $250K in the Fall of 2008
through Dec 2009)
• Owners’ Capital
McGraw-Hill/Irwin
15-287
Types of Capital
• Common Stock • Subordinated

• Preferred Stock Debentures
• Surplus • Minority Interest
in Consolidated
• Undivided Profits Subsidiaries
• Equity Reserves • Equity
Commitment
Notes
McGraw-Hill/Irwin
15-288
Relative Importance of Different Sources of

Capital
McGraw-Hill/Irwin
15-289
Reasons for Capital Regulation

The underlying assumption is that the
private marketplace does not correctly price
the impact of systemic failures. Thus, the
purpose of capital regulation is:
• To Limit the Risk of Failures

• To Preserve Public Confidence
• To Limit Losses to the Federal Government
Arising from Deposit Insurance Claims
McGraw-Hill/Irwin
15-290
The Basel Agreement on International

Capital Standards
An International Treaty Involving the
U.S., Canada, Japan and the Nations of
Western Europe to Impose Common
Capital Requirements On All Banks
Based in Those Countries
McGraw-Hill/Irwin
15-291
Quick Quiz
• What forms of capital are in use today? What
are the key differences between the different
types of capital?
• What are the most important and least
important forms of capital held by U.S.-insured
banks? How do small banks differ from large
banks in the composition of their capital
accounts and in the total volume of capital they
hold relative to their assets?
• What is the rationale for having the government
set capital standards for financial institutions
as opposed to letting the private marketplace
set those standards?
McGraw-Hill/Irwin
15-292
The Basel Agreement

• Historically, the minimum capital requirements
for banks were independent of the riskiness of
the bank
▫ Prior to 1990, banks were required to maintain:
 a primary capital-to-asset ratio of at least 5% to 6%,
and
 a minimum total capital-to-asset ratio of 6%
• The Basel Agreement of 1988 includes risk-
based capital standards for banks in 12
industrialized nations; designed to:
▫ Encourage banks to keep their capital positions
strong
▫ Reduce inequalities in capital requirements
between countries
▫ Promote fair competition
▫ Account for financial innovations (OBS, etc.)
McGraw-Hill/Irwin
15-293
The Basel Agreement

• A Bank’s Minimum Capital Requirement is
Linked to its Credit Risk
▫ The greater the credit risk, the greater the
required capital
• Stockholders' equity is deemed to be the most
valuable type of capital
• Minimum capital requirement increased to 8%
total capital to risk-adjusted assets
• Capital requirements were approximately
standardized between countries to ‘level the
playing field‘
• Capital is divided into Two Tiers
McGraw-Hill/Irwin
15-294
Tier 1 Capital
• Common Stock and Surplus
• Undivided Profits
• Qualifying Noncumulative Preferred Stock
• Minority Interests in the Equity Accounts of
Consolidated Subsidiaries
• Selected Identifiable Intangible Assets Less
Goodwill and Other Intangible Assets
McGraw-Hill/Irwin
15-295
Tier 2 Capital
• Allowance for Loan and Lease Losses
• Subordinated Debt Capital Instruments
• Mandatory Convertible Debt
• Cumulative Perpetual Preferred Stock with
Unpaid Dividends
• Equity Notes
• Other Long Term Capital Instruments that
Combine Debt and Equity Features
McGraw-Hill/Irwin
15-296
Basel Agreement Capital Requirements
• Ratio of Core Capital (Tier 1) to Risk

Weighted Assets Must Be At Least 4 Percent
• Ratio of Total Capital (Tier 1 and Tier 2) to
Risk Weighted Assets Must Be At Least 8
Percent
• The Amount of Tier 2 Capital Limited to 100
Percent of Tier 1 Capital
McGraw-Hill/Irwin
15-297
Calculating Risk-Weighted Assets
• Compute Credit-Equivalent Amount of Each

Off-Balance Sheet (OBS) Item
• Find the Appropriate Risk-Weight Category for
Each Balance Sheet and OBS Item
• Multiply Each Balance Sheet and Credit-
Equivalent OBS Item By the Correct Risk-Weight
• Add to Find the Total Amount of Risk-Weighted
Assets
• See BHC’s Call report and RBC calculations:
https://cdr.ffiec.gov/public/ManageFacsimiles.
aspx
McGraw-Hill/Irwin
15-298
Total Regulatory Capital Calculations
McGraw-Hill/Irwin
15-299
McGraw-Hill/Irwin
15-300
McGraw-Hill/Irwin
15-301
What Was Left Out of the Original Basel

Agreement
• The Most Glaring Hole with the Original Basel
Agreement is its Failure to Deal with Market Risk,
Especially Problematic During the 2007-2009 Global
Credit Crisis
• In 1995 the Basel Committee Announced New Market
Risk Capital Requirements for Their Banks
• In the U.S. Banks Can Create Their Own In-House
Models to Measure Their Market Risk Exposure, VaR,
to Determine the Maximum Amount a Bank Might
Lose Over a Specific Time Period
• Regulators Would Then Determine the Amount of
Capital Required Based Upon Their Estimate
• Banks That Continuously Estimate Their Market Risk
Poorly Would Be Required to Hold Extra Capital
McGraw-Hill/Irwin
15-302
Value at Risk (VAR) Models
A Statistical Framework for Measuring

a Bank Portfolio’s Exposure to
Changes in Market Prices or Market
Rates Over a Given Time Period
Subject to a Given Probability
McGraw-Hill/Irwin
15-303
Central Elements of VaR

• An Estimate of the Maximum Loss in a Bank’s
Portfolio Value at a Specified Level of Risk Over
10 Business Days
• A Statement of the Confidence Level
Management Attaches to its Estimate of the
Probability of Loss
• An Estimate of the Time Period Over Which the
Assets in Question Could be Liquidated Should
the Market Deteriorate
• A Statement of the Historical Time Period
Management Uses to Help Develop Forecasts of
Market Value and Market Rates of Interest
McGraw-Hill/Irwin
15-304
Basel II
• Aims to Correct the Weaknesses of Basle I

• Three Pillars of Basel II:
▫ Capital Requirements For Each Bank Are Based
on Their Own Estimated Risk Exposure from
Credit, Market and Operational Risks
▫ Supervisory Review of Each Bank’s Risk
Assessment Procedures and the Adequacy of
Its Capital
▫ Greater Disclosure of Each Bank’s True
Financial Condition
McGraw-Hill/Irwin
15-305
Credit Risk Models
• Parallel the Development of VaR Models

• IF Adverse Situation Develops in the Future,
What Magnitude of Losses Can Be Expected?
• Model Generates Risk Estimates Based On
▫ Borrower Credit Rating
▫ Probability Credit Rating Will Change
▫ Probable Amount of Recovery
▫ The Possibility of Changing Interest Rate Spreads
McGraw-Hill/Irwin
15-306
Revised Framework for Basel II
McGraw-Hill/Irwin
15-307
Capital Adequacy Categories Based

on Prompt Corrective Action (PCA)
• Well Capitalized
• Adequately Capitalized
• Undercapitalized
• Significantly Undercapitalized
• Critically Undercapitalized
McGraw-Hill/Irwin
15-308
Internal Capital Growth Rate

= ROE X Retention Ratio
= Profit Margin X Asset Utilization

X Equity Multiplier X Retention
Ratio
McGraw-Hill/Irwin
15-309
Planning to Meet a Bank’s Capital

Needs
• Raising Capital Internally
▫ Dividend Policy
▫ Internal Capital Growth Rate
• Raising Capital Externally
▫ Issuing Common Stock
▫ Issuing Preferred Stock
▫ Issuing Subordinated Notes and Debentures
▫ Selling Assets and Leasing Facilities
▫ Swapping Stock for Debt Securities
▫ Choosing the Best Alternative
McGraw-Hill/Irwin
15-310
Quick Quiz
• What are the most popular financial ratios
regulators use to assess the adequacy of bank
capital today?
• First National Bank reports the following items
on its balance sheet: cash, $200m; U.S.
government securities, $150m; residential real
estate loans, $300m; and corporate loans,
$350m. Its off-balance sheet items include
standby credit letters, $20m, and long-term
credit commitments to corporations, $160m.
What are First Nation’s total risk-weighted
assets? If the bank reports Tier 1 capital of
$30m and Tier 2 capital of $20m, does it have
a capital deficiency?
McGraw-Hill/Irwin

Bank Management and Financial Services 8e - Peter S. Rose, Sylvia C. Hudgins

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Bank Management and Financial Services 8e - Peter S. Rose, Sylvia C. Hudgins

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Chapter One

• Powerful Forces Reshaping the Industry

The Different Kinds of Financial Service

The Financial Service Competitors of Banks

• Under current U.S. federal law what must a

• What is happening to banking’s share of the

Traditional Services Offered By Banks

• Carrying Out Currency Exchange

More Recent Services Offered by

Offering Security Brokerage and

Trends Affecting Banks and Other

• Why do banks and other financial

• How have banking and the financial services

• What powerful forces are shaping financial

• Federal Deposit Insurance Company www.fdic.gov

• The Organization and Structure of the

Assets Held by U.S. FDIC-Insured

Number of U.S. FDIC-insured

43% Small ≤ $100 Million

50% Medium $100 Million -

Community Banks or Retail Banks

Money Center or Wholesale Banks

• Generally Multi-Billion Dollar Company

Common Classifications of U.S. Banks

0% 20% 40% 60% 80% 100% 120%

Nat i onal B anks 25%

0% 10% 20% 30% 40% 50% 60% 70% 80%

M ember B anks 36%

Non M ember B anks 64%

0% 10% 20% 30% 40% 50% 60% 70%

Source: FRB and FDIC, 2005

Deposits Held By Banks

Deposi t s of St at e B anks 45%

0% 10% 20% 30% 40% 50% 60%

Deposi t s of M ember B anks 77%

Deposi t s of Non M ember B anks 23%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Source: FRB and FDIC, 2005

• Offer All Services From One Office

Reasons for Growth of Branching

• Exodus of Population to Suburban

What Trend in Branch Banking Has Been

1934 14,146 2,985 17,131 0.21

1970 13,511 21,810 35,321 1.61

1982 14,451 39,784 54,235 1.75

2007 7,241 77,947 85,188 10.76

From Table 3-2; Source: FDIC

• Provide their Services Exclusively Through

Bank Holding Companies (BHC)

• A Corporation Chartered for the Purpose of

Organizational Structure of a BHC

Each subsidiary has a

Multibank Holding Company

Bank Subsidiary Nonbank Subsidiaries Bank Subsidiary

Nonbank Businesses of BHCs

Reasons for the Growth of BHCs

Reasons for Full-Service Interstate

Riegle-Neal Interstate Banking and

Proponents and Opponents of

Financial Holding Companies: GLB

Sample Organizational Structure of FHC

Bank Securities Real

• Bank Controls One or More Subsidiaries

The Changing Organization and