CHAPTER 4

BANK MANAGEMENT AND PROFITABILITY

CHAPTER OVERVIEW AND LEARNING OBJECTIVES
The previous chapter described what banks do to earn profits. This chapter examines some
issues arising in the pursuit of those profits.
The chapter describes bank income statements in terms of primary sources of income and expense,
recent trends in bank earnings and performance, and key measures of bank performance.
The chapter explains the dilemma of bank profitability versus bank safety and how managers
manage various risks while they attempt to maximize shareholder wealth. Major topics covered are
liquidity risk, interest rate risk, credit risk, and capital requirements.
CAREER PLANNING NOTE: THREE NATIONWIDE EMPLOYERS IN BANKING
Name Ticker Careers Website
ank of !merica !" http#$$careers.bankofamerica.com$overview$overview.asp
"itigroup " http#$$careers.citigroup.com$careers$homepage$default.aspx
%&Morgan "hase %&M http#$$careers.jpmorganchase.com$career$careerhome
READING THE WALL STREET JOURNAL: THE OP-ED PAGES
The opinion$editorial pages are at the back of 'ection !. (ere you will find a range of commentary by
preeminent figures in business, government, and the press about a range of national issues.
TOPIC OUTLINE AND KEY TERMS
I. Bank Ean!n"#: In$%%#$ In&'(% ) In$%%#$ E*+%n#% ) P',!#!'n -' L'an L'##%# .
N'n!n$%%#$ In&'(% ) N'n!n$%%#$ E*+%n#%

A. G'## In$%%#$ /an0 -%%1 !n&'(% 'n 2'an# an0 #%&3!$!%#.
). The major source of income for commercial banks is interest *and fees+ on loans.
a. ,.-./ of industry assets in 0--1.
b. More significant for small banks than large banks.
*)+ 'mall banks tend to make more real estate and agricultural loans.
*0+ 2arge banks tend to make more commercial and
industrial loans.
0. 3ext after loan income is interest from investment securities *more significant for
small banks than large banks+.
B. G'## !n$%%#$ %*+%n#% 'n 0%+'#!$# an0 '$4% 5''6!n"#.
). 4nterest on deposits is a major expense for banks.
a. ).5)/ of industry assets in 0--1.
b. More significant for small banks than large banks.
).)
*)+ 'mall banks rely more on deposits than large banks
*0+ 2arge banks rely more on 6ed funds and other nondeposit sources
0. 7ross interest expense on all borrowings# about 0.1)/ of industry assets.
C. N%$ In$%%#$ Ma"!n: G'## In$%%#$ In&'(% ) G'## In$%%#$ E*+%n#%
). The 8gross profit9 of a commercial bank.
0. 2arger as percentage of industry assets for small banks than for large banks.
a. 6or small banks, averages :.50/ of assets.
*)+ 'mall banks tend to make more real estate and agricultural loans
*0+ 'mall banks rely more on demand deposits
b. 6or large banks, averages 0.5-/ of assets,
*)+ 2arge banks tend to make more commercial and industrial loans
*0+ 2arge banks rely more on time deposits and nondeposit sources
D. P',!#!'n -' 2'an 2'##%#: An %*+%n#% !$%( $4a$ a00# $' a 5ank7# 2'an 2'## %#%,%.
). The loan loss reserve is a 8contra9 account deducted from gross loans.
0. anks add to their loan loss reserve in anticipation of credit quality problems in
their loan portfolio.
E. N'n!n$%%#$ In&'(% an0 E*+%n#%.
). 3oninterest income has grown in importance, especially for large banks.
a. !bout 0.)1/ of industry assets in 0--1.
b. ;xamples of noninterest income include<
*)+ 'ervice charges and 3'6 charges on demand deposits
*0+ 6ees for other bank services *safe deposit, wire transfer, etc.+
*:+ !TM surcharges
*,+ "ommissions on investment and insurance products
*=+ "redit card annual fees
0. 3oninterest expense has generally leveled off with automation, consolidation, and
economies of scale.
a. !bout 0.../ of industry assets.
b. ;xamples of noninterest expense include
*)+ &ersonnel *small banks are more labor>intensive than large banks+
*0+ Technology *large banks are more automated than small banks+
*:+ ?ccupancy
*,+ !dministration and "ompliance
*=+ Marketing
II. Bank P%-'(an&%: R%$3n 'n A,%a"% A##%$#8 R%$3n 'n A,%a"% E93!$:.
A. ROAA: R%$3n 'n A,%a"% A##%$# ; N%$ In&'(% < A,%a"% A##%$#.
). The key ratio in evaluating quality of bank management.
0. Tells how well management can exploit a given amount of assets.
:. 4ndustry average is recently around ).,/.
B. ROAE: R%$3n 'n A,%a"% E93!$: ; N%$ In&'(% < A,%a"% E93!$: Ca+!$a2.
). Tells shareholders how well management has employed their capital.
0. 4ndustry average is recently around ):/ *banks are highly leveraged+.
III. Bank Mana"%(%n$7# D!2%((a: P'-!$a5!2!$: ,#. Sa-%$: /=Ea$ 6%22 ' #2%%+ 6%22>1.
A. T4%% &'n#$!$3%n&!%#: #4a%4'20%#? 0%+'#!$'#? %"32a$'#.
).0
). 'hareholders may sell their stock if bank managers do not generate adequate
profits, driving the bank@s stock price lower.
0. Aepositors *especially uninsured ones+ may withdraw their balances if bank
managers take on too much risk, creating a liquidity crisis for the bank.
:. 4f regulators believe that management is imprudent, they may intervene in the
management of the bank or even revoke its charter.
B. Bank# &an -a!2 !n %!$4% '- $6' 6a:#: In#'2,%n&: ' !22!93!0!$:.
). In#'2,%n&:: 4nsufficiency of assets to cover liabilities.
a. anks are highly leveragedB they lack the equity 8cushion9 of other firms.
b. !ssets lose value if banks accept too much credit risk or interest rate risk.
0. I22!93!0!$:: 4nsufficiency of available funds to cover promised disbursements.
a. The most liquid assets also tend to be the least profitable.
b. Cet disbursement demand must be accommodated#
*)+ Dithdrawals by depositors
*0+ 2oan proceeds to borrowers
*:+ &ayments to employees, suppliers, and creditors
c. ;ven profitable banks can fail if they become illiquid.
IV. L!93!0!$: Mana"%(%n$: B'$4 #!0%# '- $4% Ba2an&% S4%%$.
A. O5@%&$!,%# '- L!93!0!$: Mana"%(%n$
). (old enough 8primary reserves9 *defined below+ to satisfy reserve requirements.
0. (old minimum primary and secondary reserves consistent with bank safety.
:. Minimize opportunity cost of foregone interest on liquid assets.
B. S'3&%# '- 2!93!0!$::
). 3ew deposits
0. 3ew nondeposit borrowings *e.g. 6ed funds+
:. 2oan repayment
,. 'ale of investment securities
=. &articipation or securitization of loans
1. 'ale of other assets
5. 3ew equity capital
C. L!93!0!$: %93!%(%n$#:
). Meet reserve, clearing, and settlement requirements at 6ed
0. !ccommodate deposit withdrawals
:. &ay other liabilities and expenses as they become due
,. !ccommodate loan requests
D. A##%$ (ana"%(%n$ &2a##!-!%# 5ank a##%$# !n$' -'3 5a#!& "'3+#.
). P!(a: R%#%,%# are the cash assets on a bank@s balance sheet.
a. 4mmediately available at no cost, but
b. Cield no interest, so banks try to minimize holdings of primary reserves.
c. &rimary reserves include<
*)+ vault cash
*0+ correspondent balances at other banks
*:+ excess reserve balances at the 6ed
0. S%&'n0a: R%#%,%# are short>term assets convertible quickly to cash at a price
near their purchase price.
).:
a. (ighly marketable with low default risk or price risk, but
b. Cield little interest compared to loans or riskier investments.
c. 'econdary reserves include<
*)+ Treasuries
*0+ agencies
*:+ reverse repurchase agreements
:. L'an# *and leases+ are generally less liquid and riskier than other bank assets and
thus represent the most potentially profitable use of bank funds.

,. O$4% In,%#$(%n$# include securities purchased chiefly for their income or tax
benefits, rather than their liquidity *e.g. municipal bonds+.
;. L!a5!2!$: (ana"%(%n$ #3++2%(%n$# a##%$ (ana"%(%n$ 53$ 0'%# n'$ #3+%#%0% !$.
). 2iability Management Theory assumes certain types of bank liabilities are very
sensitive to interest rate changes.
a. y raising the rate on these liabilities above the market rate, a bank
should immediately attract additional funds.
b. y lowering the rate, a bank should be able to 8run off9 funds as the
liabilities mature.
c. 8Money Market9 strategy, attempted more by large banks.
0. ank liabilities used in liability management include<
a. 3egotiable "As
b. 6ed funds
c. Eepurchase agreements
d. commercial paper
e. ;urodollar borrowings

:. Three possible uses of liability management#
a. "ounteract deposit inflows and outflows and reduce their variability.
'udden or unexpected deposit outflows can be offset immediately
by purchase new funds.
b. Meet increased loan demand. 4f expected marginal return on new loans
exceeds expected marginal cost of funds, the bank can increase
income by funding additional loans through liability management.
c. 4mmediately honor funding commitments triggered by off>balance>sheet
contingencies. anks with access to liability management mechanisms
can make contingent commitments confidently.

V. Ca+!$a2 Mana"%(%n$.
A. R'2%# '- Bank Ca+!$a2
). 6inancial cushion that enables banks to absorb temporary operating losses.
0. (elps maintain public confidence in soundness banks and banking system.
:. &rovides some protection for uninsured depositors.
,. 'ource of funds for growth *new products, services, or facilities+.
B. Ca+!$a2 A0%93a&: R%"32a$!'n
). asel 4 *asel !ccords on risk>based capital standards, )F..+
a. Eegulatory definition of bank capital# Tier ), Tier 0
*)+ T!% A Ca+!$a2 or 8core capital9
).,
i. common stock
ii. paid>in surplus
iii. undivided profits
iv. noncumulative perpetual preferred stock
v. minority interest in consolidated subsidiaries less
intabgibles
*0+ T!% B Ca+!$a2 or 8supplemental capital9
i. cumulative perpetual preferred stock
ii. loan loss reserves
iii. subordinated debt
iv. mandatory convertible debt
v. other 8hybrid9 debt
b. Eisk>weighting of assets
*)+ Eiskier assets receive higher weights
*0+ 'afer assets receive lower weights
*:+ "onversion factors for off>balance>sheet items *;xhibit ),.)-+
bring percentage of items 8on to9 balance sheet for risk>
weighting purposes
c. Minimum capital ratios
*)+ Tier ) capital at least ,/ of risk>weighted assets
*0+ Total capital *Tier ) G Tier 0+ at least ./ of risk>weighted assets
0. asel 44 *0--,+# more sophisticated modeling of credit, market, and operational
risks.
:. Eegulatory sanctions for undercapitalization are severe
VI. Mana"!n" C%0!$ R!#k.
!. Mana"!n" &%0!$ !#k '- !n0!,!03a2 2%n0!n" %2a$!'n#4!+#.
). 4dentifying and monitoring problem loans.
a. "hanges in payment patterns or credit ratings.
b. 3oncompliance or slow compliance with loan covenants.
0. 2oan workouts# restructuring debts for troubled borrowers.
a. ;mphasis shifts from earnings to recovery.
b. Typically a specialized area within the lending function.
B. Mana"!n" &%0!$ !#k a$ +'$-'2!' 2%,%2.
). Hses of internal credit risk ratings#
a. 'ystematic identification and monitoring of problem loans.
b. 'ystematic loan loss reserve allocations.
c. Eisk>based loan pricing
0. 2oan portfolio analysis# concentration and diversification by<
a. 4ndustry
b 7eographic region
c. "ollateral
d. &urpose
C. C%0!$ D%!,a$!,%#.
). ;xample# The 8"redit 'wap9
a. 'eller of swap essentially guarantees payment of some loan or
portfolio of loans
b. ank holding loan*s+ makes periodic payments to seller of swap
).=
c. "ontracts price according to credit risk
0. !dvantages#
a. "redit risk is reduced or at least deconcentrated.
b. Eelationship with borrower remains intact.
VII. M%a#3!n" an0 Mana"!n" In$%%#$ Ra$% R!#k
A. M%a#3!n" In$%%#$ Ra$% R!#k: Ma$3!$: GAP Ana2:#!#

). !n asset or a liability with an interest rate subject to change within a year is
considered 8rate>sensitive9.
0. Maturity 7!&# Eate>sensitive assets less rate>sensitive liabilitiesB 7!&IE'!>
E'2
a. &ositive 7!&# E'! J E'2B bank expects rates to rise
*)+ 4f interest rates fall>>
i. More assets than liabilities will reprice downward,
ii. thus reducing net interest income.
*0+ 4f interest rates rise<
i. More assets than liabilities will reprice upward,
ii. thus increasing net interest income
b. 3egative 7!& I E'! K E'2B bank expects rates to fall
*)+ 4f interest rates fall<
i. More liabilities than assets will reprice downward,
ii. thus increasing net interest income
*0+ 4f interest rates rise<
i. More liabilities than assets will reprice upward,
ii. thus reducing net interest income
c. Lero 7!&# 3et interest income unaffected by interest rate fluctuations.
d. The wider the 7!&, the greater the effect of interest rate changes on net
interest income.
B. Mana"!n" In$%%#$ Ra$% R!#k: D3a$!'n GAP Ana2:#!#
). Maturity 7!& provides only an approximate rule for analyzing interest rate risk.
0. To reduce reinvestment risk, banks try to match the durations of their assets
and liabilities, not their maturities.
a. Auration *"hapter =+ is a measure of the average time it takes a security
*or portfolio+ to return its present value.
b. Auration can also be viewed as the effective time until an asset reprices.
c. Auration 7!& analysis matches cash flows and their repricing
capabilities.
:. The change in the value of a portfolio for a given change in interest rates is
proportional to portfolio@s duration multiplied by the change in interest rates.
,. Auration 7!&# A7 I A! M N*MO2$MO!+*A2+P
Dhere A! I &ortfolio duration of assets
MO2 I Market value of 2iabilities
MO! I Market value of !ssets
A2 I &ortfolio duration of liabilities
).1
a. &ositive Auration 7!&# !ssets have longer duration than liabilitiesB bank
expects interest rates to fall.
*)+ 4f interest rates rise<
i. More assets than liabilities will lose value,
ii. Thus reducing the value of the bank@s equity.
*0+ 4f interest rates fall>
i. More assets than liabilities will gain value,
ii. Thus increasing the value of the bank@s equity.
b. 3egative Auration 7!&# 2iabilities have longer duration than assetsB
bank expects interest rates to rise.
*)+ 4f interest rates rise<
i. More liabilities than assets will lose value,
ii. Thus increasing the value of the bank@s equity.
*0+ 4f interest rates fall>
i. More liabilities than assets will gain value,
ii. Thus reducing the value of the bank@s equity.
c. Lero duration 7!&# ank is immunized against interest rate risk.
d. Auration 7!&s are opposite in sign from maturity 7!&s for the same risk
exposure.
C. Va23% a$ R!#k /VAR1 Ana2:#!#. Hsing historical data, bank estimates mean and Q
of changes in underlying risk factors *e.g. interest rates+ affecting asset values. !sset
duration is used to estimate potential change in value for maximum probable change in
risk factor. O!E summarizes the potential for bad outcomes in a single number#
where# RO$Rr I sensitivity of changes in asset value to changes in risk factor
RrS I potential adverse change in
risk factor within relevant time period for given confidence level
D. H%0"!n" In$%%#$ Ra$% R!#k: reducing or removing the impact, positive or negative, of
interest rate fluctuations.
). 8Microhedging9 involves a specific transaction *e.g. matched funding+.
0. 8Macrohedging9 involves the entire balance sheet.
:. Techniques 6or (edging 4nterest Eate Eisk.
a. !sset>sensitive institutions with positive maturity 7!&B negative
duration 7!&B hurt by decreasing interest rates#
*)+ uy financial futures>>falling rates would increase value of
contract, offsetting negative impact of 7!&
*0+ uy call options on financial futures
*:+ 'wap to increase their variable>rate cash outflows and increase
their fixed>rate *long>term+ cash inflows
*,+ 2engthen repricing of assetsB shorten repricing of liabilities
b. 2iability>sensitive institutions with negative maturity 7!&B positive
duration 7!&B hurt by increasing interest rates
*)+ 'ell financial futures>>increasing rates would increase value of
contract, offsetting negative impact of 7!&
*0+ uy put options on financial futures
).5
*:+ 'wap long>term, fixed>rate payments for variable>rate payments
*,+ 'horten repricing of assetsB lengthen repricing of liabilities
COMPLETION CUESTIONS
). ank managers must balance a trade>off between TTTTTTTTTT and TTTTTTTTTTTT.
0. The loan loss reserve is a 8TTTTTTT9 account deducted from gross loans.
:. 6or purposes of liquidity management, vault cash is an example of TTTTTT reserves.
,. 4f E'! K E'2 the maturity 7!& is TTTTTTTTT and net interest income will TTTTTTTTT if interest
rates rise.
=. Hndivided profits are part of TTTTTTTTT capital.
1. anks purchase financial futures to hedge against effects of a TTTTT in interest rates.
5. TTTTTT management theory assumes funds can be readily obtained in the money market by
offering more than the market rate.
.. Matched>funding is TTTTT >hedging. uying futures to hedge a whole balance sheet is TTTTT
>hedging.
F. ! positive maturity 7!& implies a TTTTTTTT duration 7!&.
)-. Total capital must be at least ./ of TTTTTTTTTTTTTTTT assets.
TRUE<FALSE CUESTIONS
T 6 ). ! high positive 7!& is more risky than a high negative 7!&.
T 6 0. 8&rimary reserves9 and 8required reserves9 are essentially the same thing.
T 6 :. ;xcess reserves may be used to meet liquidity needs.
T 6 ,. ank capital is a cash reserve to pay depositors in case of failure.
T 6 =. 8Tier )9 capital is more permanent than 8Tier 09 capital.
T 6 1. anks need liquidity for both deposit withdrawals and loan demand.
T 6 5. ! bank with a positive duration 7!& expects interest rates to fall.
T 6 .. &rimary reserves maximize liquidity but also earn income.
T 6 F. 2iability management has superseded asset management in managing liquidity.
T 6 )-. ! bank with a negative maturity 7!& expects interest rates to rise.
)..
MULTIPLE-CHOICE CUESTIONS
). ank capital standards are expressed in terms of percentages of
a. assets.
b. deposits.
c. risk>weighted assets.
d. industry averages.
0. The major source of bank revenue is from
a. loans.
b. investments.
c. service charges.
d. 8off>balance>sheet9 activities.
:. The major noninterest expense for banks is
a. occupancy expense.
b. income taxes.
c. salaries and wages.
d. provision for loan losses.
,. ! bank profit ratio measuring the performance of total assets is called
a. margin.
b. E?!;.
c. capital$asset ratio.
d. E?!!.
=. alancing profitability and safety for banks is more difficult than for other businesses because
a. banks have low capital$asset ratios.
b. banks make very risky loans.
c. most bank liabilities are short term.
d. both a and c.
1. ! bank can fail either of two ways#
a. too much 7!& or too little 7!&.
b. insufficient leverage or insufficient market share.
c. insufficient risk or insufficient return.
d. illiquidity or insolvency.
5. The major sources of bank liquidity are TTTTT and TTTTTB the major uses are TTTTT and TTTTT.
a. loans and depositsB borrowed funds and selling assets
b. borrowed funds and loansB deposits and selling assets
c. selling assets and borrowed fundsB loans and deposit withdrawal
d. borrowed funds and loansB securities and deposit withdrawal
.. The important characteristics of secondary reserves are
a. low cost and immediate availability.
b. excellent liquidity while earning some interest.
c. nonearning asset with immediate liquidity.
d. high income with low risk.
).F
F. 2iability management assumes
a. asset management has been utilized to the fullest extent possible.
b. the bank is adequately capitalized.
c. the bank can finance in money markets any time.
d. primary and secondary reserves are sufficient for any liquidity needs.
)-. Maturity 7!& is defined as
a. rate sensitive assets divided by rate sensitive liabilities.
b. fixed rate assets minus rate sensitive liabilities.
c. rate sensitive liabilities plus rate sensitive assets.
d. rate sensitive assets minus rate sensitive liabilities.
SOLUTIONS TO COMPLETION CUESTIONS
). safetyB profitability
0. contra
:. primary
,. negativeB decrease
=. 8Tier )9 or 8core9
1. decrease
5. liability
.. microB macro
F. negative
)-. risk>weighted
SOLUTIONS TO TRUE-FALSE CUESTIONS
). 6 ! large 7!& in either direction subjects the bank to significant interest rate risk.
0. 6 &rimary reserves are a financial classification of assets for liquidity management
purposesB required reserves are a regulatory classification. There is significant overlap
between them in terms of the assets qualifying, but they are not the same thing.
:. T y definition, excess reserves are among the most liquid bank assets.
,. 6 ank capital is an ultimate 8cushion9 but not an immediate cash reserve. ank
capital is a set of credit balances on the right side of the balance sheet, not an asset.
=. T 8Tier 09 capital will not ultimately absorb losses for the going concern.
1. T ! bank has to supply liquidity on both sides of the balance sheet.

5. T ! drop in interest rates would increase the value of both assets and liabilities, but
if the duration of assets were greater than that of liabilities, the value of assets would
increase more than that of liabilities and the value of the bank@s equity would increase.
.. 6 &rimary reserves *cash and deposits in banks+ are almost always nonearning assets.
)F-
F. 6 Most banks still rely on asset managementB liability management is more feasible for large
banks with access to the money markets.
)-. 6 !s interest rates rise, more E'2s reprice upward than E'!s. 3et interest income falls.
SOLUTIONS TO MULTIPLE-CHOICE CUESTIONS
). c "apital standards are in terms of percentages of risk>weighted assets.
0. a 2oans are the major source of revenue.
:. c 'alaries and wages are the major operating expense of banks.
,. d The return on average assets *E?!!+ tells how well management uses assets.
=. d 2ower equity and deposit variability mean that banks must be liquid and safe but
still provide income.
1. d ! bank can fail from either illiquidity or insolvency.
5. c 2iquidity may be observed from a sources$uses perspective.
.. b 'econdary reserves are liquid, earning assets such as Treasury bills.
F. c 2iability management assumes the market will always lend to the bank if the bank
pays the market price or more.
)-. d 7!& I E'! > E'2
)F)