Bank Management

Book by Timothy W. Koch & S. Scott MacDonald

Review and Article by GlobalMacroForex

Banks are the biggest players in the forex market and directly influence the money supply through fractional reserve banking.

While this textbook is designed for an undergraduate in a banking program or MBA program, I’m writing this for an investor to understand the banking system works.  I’ve added the section “How Deposit types effect Global Macro” which was not in the original textbook.  We’ll be covering:

·      Types of Deposits

·      How Deposit types effects Global Macro

·      Fed Funds Rate

·      Reserve Balances with the Fed

·      Basel III

·      Interest Rate Sensitivity

·      Managing Rate Risk

·      Yield Curve Strategies

Let’s dive right in…

Types of Deposits

Banks have different types of deposits: demand deposits and time deposits.  And the sources of those funds could be Retail (Core) deposits and/or wholesale deposits.  Demand deposits can be redeemed on command as we discussed in fractional reserve banking explained.  So demand deposits are the ones that banks can “create money”, while time deposits (called certificates of deposit/CDs) are just like bonds.

Retail deposits are referred to as core deposits and come from everyday people who deposit money at the bank, typically local residents near a branch referred to as core deposits.  Retail core deposits generally are a cheaper source of funding for a bank because retail customers are considering liquidity needs more than the interest rate.  They typically pick a bank based on location and not return, this is referred to as interest elastic.

Wholesale deposits are deposits from institutional investors.  Basically, the bank is “buying” funds with wholesale funding as they negotiate a CD rate with the institutional seller.  These funds typically have to pay a higher interest rate because the wholesaler is very discriminating on the interest rate, not branch location.  These funds are referred to as “hot money” by regulators because the funding can easily dry up in a crisis, so more capital is required to hold against them, than if it was a retail deposit.

Typically because local banks are able to get more core deposits (by being in the communities with a branch and offering better customer service), they can get a lower cost of deposits (funding).  They then, in turn, sell their funds to the larger national banks. 

How deposit types effect Global Macro

An overreliance on wholesale deposits can be a huge problem in credit crunches.  As we discussed previously, this was a big cause of the Eurozone crisis.  Since the Spanish banks were borrowing on the interbank from German banks, once their assets started to drop, the funding dried up as Germans didn’t want to renew.  This chart that we already discussed from The Euro and the Battle of Ideas demonstrates the concept.

As we discussed in the 1929 Great Depression article and my original article on fractional reserve banking, when so many time deposits are relying on just a few demand deposits it creates an easy to bubble to pop.  Since there’s a lot of leverage as well as the inability of the system (not an individual bank but the entire system) to keep creating fractional reserve money. This creates an intense problem in time deposit assets, as was the case with the 2007-8 real estate bubble as well as the 1929 stock market crash Great Depression.  I made this chart to categorize the situations.

Fund Funds Rate

In a previous article, we discussed how the interbank markets works.  Basically, banks can use CHIPS to net transactions for wire transfers of customers, or Fedwire to actually send the funds overnight.  When banks borrow from each other through Fedwire, the rate is the Fed Funds rate.  (This is the rate the Federal Reserve tries to artificially manipulate through open market operations).  The Fed does this by buying short-term US Treasury securities. 

If banks can’t get any real return on Treasury securities, then they would rather lend overnight to each other, thus driving down the Fed Funds rate.

Reserve Balances with Fed

So when one bank sends another bank money through Fedwire for overnight borrowing (because Treasury bills pay so little) it goes through the Fed,

Now banks have to keep reserves at the Federal Reserve (a fraction of the total demand deposits) so instead of physically mailing the other bank paper money from a vault, instead the Federal Reserve just transfers funds from Bank 1’s reserves to banks 2’s reserves,

 Basel III

Basel is a canton in Switzerland that’s right at the junction between France, Germany, and the Switzerland.

Here is the Bank of International Settlements, which is the Central bankers’ Central bank.  They dictate not only worldwide monetary policy but also set rules for all developed nations’ banks.  After the US financial crisis, they released the 3rd set of regulations entitled Basel III, which requires banks to have equity equal to certain amounts based on the perceived riskiness of these underlying assets.  These risk weights are decided by the Bank of International Settlements.

(picture)

This textbook primarily goes over Basel II, which as we talked about previously in my article on Critical Review, Basel II created perverse incentives that were a cause of the financial crisis in 2007.  However, since then they have implemented Basel III.

Interest Rate Sensitivity

Banks borrow from depositors and then lend the money out to businesses, homeowners, credit cards, and/or other types of loans.  In order to profit from this, the bank usually has to borrow and loan at different time maturities to benefit from the yield curve.

The yield curve is a theoretical concept of comparing the yields of different maturity lengths of the security.  Since longer-dated securities/bonds typically offer higher interest rates to entice you to part with your money for longer periods of time, banks borrow in the short-term via core deposits or wholesale deposits, then lend that money out at the end of the yield curve (farther away in time).

 This distance between far longer-term yields and short-term yields is called the spread.  As the spreads become smaller, a bank’s interest-based profit margins diminish.  If it is due to rising short-term rates, this is bad for the overall market.  This situation is known as ‘basis risk’.

But if it’s due to falling long-term rates, banks will likely get capital gains on existing bonds (bond prices rise as yields fall) as well as increased loan revenue (albeit at smaller margins) because assets are rising causing more people to want loans (for example to buy assets like a home or start a business).

When short-term rates spike, banks use political force to lobby the Central bank to buy short-term government securities.  This lowers the overall short-term rates for the market and lowers the short-term interbank wholesale funding rate, known as the Fed Funds rate. It also lowers LIBOR.

If all rates go up and down in unison, it does not change the spread but it can pronounced effects on the bank’s balance sheet.  This is because banks own bonds which can go down or up in value as interest rates shift.

ALCO is an acronym for the Asset Liability Management Committee. They oversee the risk management in place for changes in interest rate.  GAP and Earnings Sensitivity Analysis are two measurements of a bank’s sensitivity to interest rate changes.  It compares the changes in the value of assets compared to liabilities.  Assets are put into time buckets, for example, 0-30 days or 31-90 days.  Then changes to interest rates are measured against the assets and liabilities within each time bucket category.  The duration gap measures how well matched are the timings of cash inflows (from assets) and cash outflows (from liabilities).

(pg 274, Rate Sensitivity Analysis)

The magnitude of the GAP provides information regarding how much net interest income may change when rates change.

GAP ratio = Rate Sensitivity of Assets / Rate Sensitivity of Liabilities

 (pg 267 charts)

Duration is the concept of how much the value of a bond changes due to a change in interest rates.  Duration GAP is applying this concept to the entire portfolio of assets and liabilities. 

Duration GAP: the difference in the price sensitivity of interest-yielding assets and the price sensitivity of liabilities (of the organization) to a change in market interest rates (yields).

Duration can also be considered the time it takes to repay the principal of a bond.  By looking at the Duration GAP, a bank is effectively asking, comparing my assets and my liabilities which will bring me cash flows of the principal back sooner?

As we discussed in my previous article on Yield Curve Dynamics, not all bonds are affected equally by changes in interest rates.  The longer the maturity of the bond, (more time until principal) the more it changes in price.  So for example, let’s say all bonds shift up in rates (parallel yield curve shift)

Then the bonds further on the yield curve will change more in price and the bonds at the start of the curve (short-term) will change less in price.

Because the bank’s assets vs. liabilities can change in value, it will affect the owner’s equity and net income.  Duration GAP measures this change so banks can adjust their portfolio to prepare for these overall rate changes.  But in reality, it’s very difficult to completely eliminate this risk.

“It is virtually impossible for a bank to have a zero GAP given the complexity and size of bank balance sheets.”

Managing Rate Risk

If the DGAP is positive, it means that upwards movements in rates are decreasing the value of assets more than decreasing the value of liabilities.  This is bad because it means what you own went down in value more than what you owe.  For example, consider a bank whose assets went down by $5 million but whose liabilities went down by $3 million.

In this case, the bank has a $2 million loss.  DGAP is positive.  To prevent this, when a bank has a positive DGAP it should:

Shorten asset durations by:

-Buying short-term securities and selling long-term securities

-Making floating-rate loans and selling fixed-rate loans

Lengthen liability durations by

-Issuing longer-term CDs

-borrowing via longer-term FHLB advances

-obtaining more core transactions accounts from stable sources

Now let’s consider if rates go down.  In this case, the value of all the bonds goes up.

If the bank’s assets are too short-term on the curve, while their liabilities are longer-term maturities, then the assets are falling faster in value than the liabilities.  In other words, you own much less but owe only slightly less.

You could get this type of situation for example if your assets were all issued a long time ago so have moved down the yield curve.  In addition, your assets might have a high percentage of overnight loans but liabilities/borrowing were on a longer-term basis.  This situation is known as negative DGAP.  A bank with a negative DGAP should:

Lengthen asset durations by:

-buying long-term securities and selling short-term securities

-buying securities without call options

-making fixed-rate loans and selling floating-rate loans

Shorten liability durations by:

-issuing shorter-term CDs

-borrowing via shorter-term FHLB advances (government subsidy)

-using short-term purchased liability funding from federal funds and repurchase agreements

When dealing with commercial loans, positive DGAP is a bigger problem than negative DGAP.  This is because it is easy for a bank to lend for longer periods of time as long as the yield curve is positively sloped.  As the spreads between long-term and short-term rates narrow (flattening yield curve), it makes it harder and harder for positive DGAP banks to lend sooner in time, since the profit margin is shrinking.

When dealing with mortgages, negative DGAP can become a significant problem because borrowers can refinance or prepay when rates drop.  This limits the upside potential of the assets from this call option.

Yield Curve Strategies

When the yield curve inverts there is usually a recession. 

Bank portfolio managers can take advantage of this by:

1.   Buy long-term noncallable securities

2.   Make fixed-rate noncallable loans

3.   Price deposits on a floating rate basis

4.   Follow strategies to become more liability sensitive and/or lengthen the duration of assets vs the duration of liabilities

By trying to get floating-rate liabilities, but having more fixed-rate assets, the bank is trying to lock in their asset values at the higher rates.  As rates fall, they get the capital gains increases on the assets, but their liabilities fall also.  It increases the spread and captures this unique situation.  When the yield curve spread peaks, they want to do the opposite.