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Understanding Bank Balance Sheets: Risks, Capital, and Management Techniques

Explore the complexities of bank balance sheets, risks associated with assets and liabilities, bank capital importance, profitability factors, and key risk management strategies such as liquidity risk, credit risk, interest-rate risk, and other operational risks.

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Understanding Bank Balance Sheets: Risks, Capital, and Management Techniques

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  1. Chapter 12. Banks and Bank Mgmt. • Balance sheet • Bank Risks

  2. Bank Balance Sheet • Assets: Uses of funds • 2007: $10.5 trillion • Liabilities: Sources of funds • $9.4 trillion

  3. Assets • cash items (< $1 trillion) • reserves -- required -- excess • deposits at other banks • cash items in collection

  4. securities ($2.4 trillion) • debt securities • U.S. gov’t debt • municipal debt • loans ($6.9 trillion, 66% of assets) • commercial • real estate • consumer • interbank

  5. Liabilities • deposits ($6.4 trillion, 68%) • transaction deposits • Nontransaction deposits ($5.9 trillion) • Savings • CDs (large CDs, >$100,000 can be resold)

  6. borrowed funds • discount loans (Federal Reserve) • federal funds (other banks) • repos • eurodollar loans • commercial paper

  7. Bank capital • or net worth = assets – liabilities = $1.1 trillion 10 to 1 leverage! • banks have capital requirement • cushion against bad loan losses

  8. Bank capital and profits • ROE = net after tax profit bank capital • Higher bank capital lowers ROE

  9. Bank risks • Liquidity risk • Credit risk • Interest-rate risk • Other • Trading • Foreign currency • sovereignty • operational

  10. Liquidity Risks • Risk of running short of cash • need cash to deal with deposit outflows • but holding cash drags down profits • Holding too little cash, bank incurs costs of raising additional funds

  11. Credit risk • Risk of unpaid loans • How to minimize? • Credit risk analysis • Credit history, scores • Monitoring, collateral • Diversification • Tradeoff with the gains of loan specialization

  12. Interest-rate risk • changes in interest rates affect BOTH assets and liabilities • assets • changes VALUE • changes the amount of interest income • depends on whether LT or ST

  13. liabilities • cost of funds goes up with interest rates -- rates on CDs, money market accounts, savings, checking

  14. banks typically borrow short-term and lend long-term • so rate sensitive liabilities > rate sensitive assets • so as interest rates rise • costs increase faster than income • bank profits fall • banks must manage interest rate risk • Floating rate loans, swaps

  15. Other Risks • Trading risk • Securities fluctuate in values • Traders do not personally corver losses • Solution: monitoring, limits

  16. Foreign exchange risk • Currency fluctuations affect value of foreign assets • Use derivatives to manage • Sovereign risk • Governments interfere with currency transfers

  17. Operational risk • Damage to physical/computer infrastructure • Backup systems, geographically dispersed

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