Lecture Notes Commercial Bank Management

1. Program MM Banking STIE Perbanas Lecture Notes Commercial Bank Management

2. Bank balance sheet Total assets = total liabilities + capital • Source of funds (liabilities): • Deposits (demand, savings and time) – third party funds (Dana Pihak Ketiga/DPK) • Borrowed funds, subordinated notes and bonds • Capital • Bank uses of funds (assets): • Cash assets – vault cash, reserve at central bank, balance on other banks • Federal funds sold dan reverse repo • Investments – government bonds/securities • Loans and leases

3. Bank balance sheet Source of funds • Deposits • Deposits are the principal source of funds • Demand deposits • Checking/ giro account – owners entitled to write checks or giro • Savings deposits/accounts • Money market deposit accounts • Time deposits • Certificates of deposits • Negotiable certificate of deposits (NCD) • Borrowed funds • USA • Federal funds– o/n interbank call money • Repos • Banker’s acceptance • Federal Reserve Bank loans – short term (15 days) • Indonesia • Interbank call money (Pasar Uang Antar Bank/PUAB) • BLBI (but no longer since UU 23/1999)

4. The bulk of commercial bank funds - about two-thirds of the total – comes from deposits Principal nondeposits sources of funds for banks include purchases of reserves from other banks, securities repurchace agreements, and the issuance of capital notes. Recently banks have turned to new nondeposit funds sources, including floating-rate CDs and notes sold international markets, sales of loans, securitization of selected assets. Equity capital (or networth) applied by a bank’s stockholders provides only a minor portion of (around 10% on average, but at least 8% according Basle II) total funds for most banks today. Bank balance sheetSource of funds

5. Securitizations of bank loans to raise funds Bank balance sheetSource of funds Some loans removed From balance sheet, pooled, and placed under the control of separate corporation or trust Securities are issued against the pool of loans and sold to capital market Bank loans Proceeds of security sales flow back to the bank as a new sorce of funds

6. Bank balance sheet Uses of funds • Cash assets– vault cash, reserve or deposit at central bank, balance on other banks • Required reserves • Excess reserves • Investment • Government bonds/bills • Local government securities • Central bank bills (SBI in Indonesia) • Loans and leases • Loans are primary bussiness of commercial banks • Loand are the most profitable but subject to greater default risk • May be secured (with collateral) or unsecured • Fixed rate or floating rate loans • Types of loans: commercial and industrial loans, interbank loans, real estate loans, agricultural loans, consumer loans (loans to individuals, e.g. credit card) • Lease financing

7. Cash (primary reserves) is the banker’s first line of defense againts withdrawals by deposits and customer demand for loans Commercial banks hold securites (mostly short-term) acquired in the open market as an investment and as a secondary reserves to help meet short-term cash needs. Loans are among the highest yielding assets a bank can add to its portfolio, and they often provide the largest portion of traditional banks’ operating revenue. Bank balance sheetUses of funds

8. Bank balance sheet Uses of funds • Loans pricing • Subject to risk assessment • The prime rate – benchmark or base rate (charged to the most creditworthy customers) • Base rate loan pricing • r = BR + DR + TM + CF • r = individual customer loan rate • BR = the base rate • DR = adjustment for default risk above base rate customer • TM = adjustment for term to maturity • CF = competitive factor • Cost of loanable fund

9. Basic Operation of a Bank • Asset transformation • transforming deposits into loans • “borrows short and lends long” • Providing payments services • T-account (simplified balance sheet) presentation: • Suppose Melisa opens an checking account at Lippo bank with Rp 100 million cash (banknotes) • Felix opens at the same bank with Rp 100 million check written on her account at BCA. • Lippo Bank

10. Basic operation of a bank After collection (through check clearing process - interbank), T-acc of the two banks: Lippo Bank BCA When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves

11. Basic operation of a bank • What next Lippo Bank is going to do with additional reserves of Rp 200 million? • Suppose the required reserves (imposed by the central bank) is 10%, there will be 90% of excess reserves available to lend. Lippo Bank

12. Basic operation of a bank: Deposits or Money creation • Let assume the debtor receiving Rp180 million from Lippo Bank put the money back at her account at the same bank; deposits at Lippo bank will increase by the same amount, the loan operation will continue. Lippo Bank

13. Banks have the power to create money in the form of new checkable deposits, credit card lines, debit cards, and other immediately spendable funds. The banking system as a whole can create a volume of money equal to a multiple of any excess reserves deposits with it simply by making loans and purchasing securities. Each bank reserves may divided into 2 categories: Required reserves Excess reserves The distinction between excess and required reserves is important because it plays a key role in the growth of credit in the economy and the creation of money in the banking system. When all excess reserves extended (making loans), the banking system is called “loaned-up”. Basic operation of a bank: Deposits or Money creation

14. Liquidity management Make sure enough cash to meet deposit withdrawal Too much cash is costly Assets management Acquiring assets with low risk Diversifying assets holdings Liability management Acquiring funds with low cost Capital management Maintain capital adequacy General Principle of Bank Management

15. Banks need to maintain adequate reserves to meet deposit withdrawal and reserve requirement If a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet. What if a bank holds insufficient reserves? Either fail to meet deposit withdrawal Or fail to meet required reserves  penalty What that bank will do? it can either borrow from other banks (fed funds in US and PUAB in Indonesia), or sell securities (T-bills/bonds), or borrow from the central bank (discount rates). Liquidity management

16. Liquidity management  With 10% reserve requirement, bank still has excess reserves of Rp 1 million: no changes needed in balance sheet 17-16

17.  With 10% reserve requirement, bank has Rp 9 million reserve shortfall Liquidity management

18. Liquidity management What the bank will do?

19.  Excess reserves are insurance against above 4 costs from deposit outflows; Banks hold excess reserves even though loans or securities earn a higher return. (Empirical evidence in Indonesia, RR=5%, average ER= 2%) Liquidity management 17-19

20. Maximizing profits by seeking the highest returns possible for loans and securities, reduce risk, and make adequate provisions for liquidity by holding liquid assets Four ways in accomplishing these three goals: Find borrowers who will pay high interest rates and unlikely to default – the role of bank’s loan officers. Purchase securities with high returns and low risk. Diversifying assets portfolio (short, long-term) to lower risk – “do not put your eggs into one basket”. Manage liquidity of the assets, easy to get cash to meet reserve requirement – how much excess reserves must be held to avoid cost from a deposit outflow. Assets management

21. Managing the source of funds, from deposits, to CDs, to other debt – banks no longer depends primarily deposits - When see loan opportunities, borrow or issue CDs to acquire funds So a bank can target goals for their assets growth and acquire funds by issuing liabilities in the money market or by borrowing from another bank (interbank money market – o/n federal funds in the US market). Flexibility in the liability management and the search for higher profits have stimulated banks to increase proportion of loans (which earn higher income) in their total assets. Liability management

22. Bank capital is a cushion that prevents bank failure, in case the bank cannot satisfy its obligation to pay its depositors or creditors The higher is bank capital, the lower is return on equity ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM (Equity multiplier) = Assets/Equity Capital ROE = ROAEM Capital , EM, ROE Capital management

23. Tradeoff between safety (high capital) and ROE Banks also hold capital to meet capital adequacy requirements imposed by authorities Strategies for Managing Capital Sell or retire stock Change dividends to change retained earnings Change asset growth Capital management

24. In today’s more competitive environment, off-balance sheet activities have grown to be a source of bank’s profit – activities that affect bank profits but do not appear on the bank balance sheets. Off-balance activities generate income: Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit Financial futures and options Foreign exchange trading Interest rate swaps Loan sales All these activities involve risk Payments services on behalf of customers – low risk Off-balance sheet activities

25. Four dimensions of bank performance today: The bank’s market value or stock price The bank’s rate of return or profitability ratios The bank’s risk exposure The bank’s operating efficiency. Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts: Operating Income Operating Expenses Net Operating Income Note how this is different from, say, a manufacturing firm’s income statement. Measuring Bank Performance

26. Banks' Income Statement

27. Bank’s income statement & Balance sheetBank Central Asia Profit & Loss Statement Balance sheet

28. Capital adequacy ratio (CAR) – capital/risk weighted assets Earning assets quality ratio – classified earning assets/total earning assets Return on assets ratio – annual profit before taxes/average assets Operations expenses to operations income ratio Liquid asset to liquid liabilities ratio Loan to deposit ratio (LDR) – total credit/third party funds (deposits) Non-performing loan ratio (NPL) – credits that are sub-standard,dubtful and loss/ total credits Net interest margin (NIM) ratio –net interest income/average earning assets Note: See Indonesian Banking Statistics (Bank Indonesia monthly publication) Selected banking performance indicators

29. Recent Trends in Bank Performance Measures ROA = Net Profits/ Assets ROE = Net Profits/ Equity Capital NIM = [Interest Income - Interest Expenses]/ Assets As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows historical averages for key bank performance measures in US.