Exercises

Manage the liquidity of the Timberlake Bank given the following scenarios. The legal reserve requirement is 5 percent. Use this initial balance sheet to answer each question:

1. Deposits outflows of $3.5 and inflows of $3.5.

2. Deposit outflows of $4.2 and inflows of $5.8.

3. Deposit outflows of $3.7 and inflows of $0.2.

4. A large depositor says that she needs $1.5 million from her checking account, but just for two days. Otherwise, net outflows are expected to be about zero.

5. Net transaction deposit outflows are zero, but there is a $5 million net outflow from nontransaction deposits.

   Asset management entails the usual trade-off between risk and return. Bankers want to make safe, high-interest rate loans but, of course, few of those are to be found. So they must choose between giving up some interest or suffering higher default rates. Bankers must also be careful to diversify, to make loans to a variety of different types of borrowers, preferably in different geographic regions. That is because sometimes entire sectors or regions go bust and the bank will too if most of its loans were made in a depressed region or to the struggling group. Finally, bankers must bear in mind that they need some secondary reserves, some assets that can be quickly and cheaply sold to bolster reserves if need be.

   Today, bankers’ decisions about how many excess and secondary reserves to hold is partly a function of their ability to manage their liabilities. Historically, bankers did not try to manage their liabilities. They took deposit levels as given and worked from there. Since the 1960s, however, banks, especially big ones in New York, Chicago, and San Francisco (the so-called money centers), began to actively manage their liabilities by

   1. actively trying to attract deposits;
   2. selling large denomination NCDs to institutional investors;
   3. borrowing from other banks in the overnight federal funds market.

   Recent regulatory reforms (discussed in greater detail in Chapter 11 "The Economics of Financial Regulation") have made it easier for banks to actively manage their liabilities. In typical times today, if a bank has a profitable loan opportunity, it will not hesitate to raise the funds by borrowing from another bank, attracting deposits with higher interest rates, or selling an NCD.

   That leaves us with capital adequacy management. Like reserves, banks would hold capital without regulatory prodding because equity or net worth buffers banks (and other companies) from temporary losses, downturns, and setbacks. However, like reserves, capital is costly. The more there is of it, holding profits constant, the less each dollar of it earns. So capital, like reserves, is now subject to minimums called capital requirements.

   Consider the balance sheet of Safety Bank:

   Safety Bank	Balance Sheet (Billions USD)
   Assets	Liabilities
   Reserves $1	Transaction deposits $10
   Securities $5	Nontransaction deposits $75
   Loans $90	Borrowings $5
   Other assets $4	Capital $10
   Totals $100	$100

   If $5 billion of its loans went bad and had to be completely written off, Safety Bank would still be in operation:

   Safety Bank	Balance Sheet (Billions USD)
   Assets	Liabilities
   Reserves $1	Transaction deposits $10
   Securities $5	Nontransaction deposits $75
   Loans $85	Borrowings $5
   Other assets $4	Capital $5
   Totals $95	$95

   Now, consider Shaky Bank:

   Shaky Bank	Balance Sheet (Billions USD)
   Assets	Liabilities
   Reserves $1	Transaction deposits $10
   Securities $5	Nontransaction deposits $80
   Loans $90	Borrowings $9
   Other assets $4	Capital $1
   Totals $100	$100

   If $5 billion of its loans go bad, so too does Shaky.

   Shaky Bank	Balance Sheet (Billions USD)
   Assets	Liabilities
   Reserves $1	Transaction deposits $10
   Securities $5	Nontransaction deposits $80
   Loans $85	Borrowings $9
   Other assets $4	Capital −$4
   Totals $95	$95

   You don’t need to be a certified public accountant (CPA) to know that red numbers and negative signs are not good news. Shaky Bank is a now a new kind of bank, bankrupt.

   Why would a banker manage capital like Shaky Bank instead of like Safety Bank? In a word, profitability. There are two major ways of measuring profitability: return on assets (ROA) and return on equity (ROE).

   ROA = net after-tax profit/assets

   ROE = net after-tax profit/equity (capital, net worth)

   Suppose that, before the loan debacle, both Safety and Shaky Bank had $10 billion in profits. The ROA of both would be 10/100 = .10. But Shaky Bank’s ROE, what shareholders care about most, would leave Safety Bank in the dust because Shaky Bank is more highly leveraged (more assets per dollar of equity).

   Shaky Bank ROE = 10/1 = 10

   Safety Bank ROE = 10/10 = 1

   This, of course, is nothing more than the standard risk-return trade-off applied to banking. Regulators in many countries have therefore found it prudent to mandate capital adequacy standards to ensure that some bankers are not taking on high levels of risk in the pursuit of high profits.

   Bankers manage bank capital in several ways:

   1. By buying (selling) their own bank’s stock in the open market. That reduces (increases) the number of shares outstanding, raising (decreasing) capital and ROE, ceteris paribus
   2. By paying (withholding) dividends, which decreases (increases) capital, increasing (decreasing) ROE, all else equal
   3. By increasing (decreasing) the bank’s assets, which, with capital held constant, increases (decreases) ROE

   These same concepts and principles—asset, liability, capital, and liquidity management, and capital-liquidity and capital-profitability trade-offs—apply to other types of financial intermediaries as well, though the details, of course, differ.