This article seeks to unpack how banks, in general, are managed. In doing so, the article starts by explaining, in brief, the balance sheet, which is a financial statement that takes a snapshot of what the bank owns (assets) and owes (liabilities) at a given moment. The key equation here is a simple one depicted below:
Capital/Equity (Net worth) = Assets (uses of funds) – Liabilities (sources of funds)
A bank’s statement of financial position lists the sources of funds of a bank (liabilities) and the uses of funds of a bank (assets). Liabilities are money that companies borrow to buy assets, which is why liabilities are sometimes called “sources of funds” and assets, “uses of funds.” The hope is that the liabilities will cost less than what the assets will earn. For example, a bank will borrow at 2 percent and lend at 5 percent or more. The difference between the two, called the gross spread, is the most important aspect of bank profitability. The bank’s expenses and taxes, as well as the cost of doing business, are the other major factors that determine the bank’s profitability.
A bank manager has four basic concerns:
1. Liquidity management - making sure that the bank has enough cash to cover depositors’ requests for withdrawals (deposit outflows). The bank must ensure that they hold enough ready cash to pay its depositors when there are depositors’ outflows i.e., a bank must hold excess cash If the bank does not hold excess reserves, it must meet deposit outflows by borrowing, selling securities, or reducing its loans. All these options are costly; excess reserves provide insurance against these costs.
2. Asset management - acquiring assets with the highest return and the lowest risk by diversifying asset holdings. To maximize profits, a bank must simultaneously seek the highest returns possible on loans and securities, reduce risk, make adequate provisions for liquidity. The bank must hold a mix of assets that provides the highest return with the lowest risk. Thus, asset management involves four basic principles:
(i) Finding borrowers who will pay high-interest rates but who are unlikely to default.
(ii) Finding securities with high returns and low risk.
(ii) Diversifying the bank’s asset holdings to minimize risk: holding many types of securities and making many types of loans offers protection when there are losses in one type of security or one type of loan.
(iv) Holding some liquid assets, including excess reserves and TBs (“secondary reserves”), to protect against deposit outflows, even though the interest rate on these assets may be lower.
3. Liability management - acquiring funds at the lowest cost. Demand deposits are a bank’s lowest-cost source of funds. But demand deposits are unlikely to provide a bank with all of the funds that it needs. Thus, the bank may obtain additional funds at higher costs by borrowing from other banks.
Capital adequacy management - maintaining sufficient capital while still providing decent returns to shareholders. Banks must make decisions about the amount of capital they need to hold for three reasons:
(i) Bank capital helps prevent bank failures
(ii) The amount of capital affects returns for the owners of the bank (equity holders)
(iii) A minimum amount of bank capital is required by regulatory authorities.
By maintaining more capital, it protects itself against a decline in the value of its assets.
But by maintaining less capital, it can pay more dividends and thereby provide its shareholders with a better return on their investment.
Major problems faced by Bank managers and why is bank management closely regulated?
Bankers must manage their assets and liabilities to ensure three conditions:
1. That the bank has enough reserves on hand to pay for any deposit outflows (net decreases in deposits) but not so many as to render the bank unprofitable. This tricky trade-off is called liquidity management.
2. To earns profits and to be able to do so, the bank must own a diverse portfolio of remunerative assets. This is known as asset management. It must also obtain its funds as cheaply as possible, which is known as liability management.
3. A bank should have sufficient net worth or equity capital to maintain a cushion against bankruptcy or regulatory attention but not so much that the bank is unprofitable. This second tricky trade-off is called capital adequacy management.
In their quest to earn profits and manage liquidity and capital, banks face two major risks: credit risk, the risk of borrowers defaulting on the loans and securities it owns, and interest rate risk, the risk that interest rate changes will decrease the returns on its assets and/or increase the cost of its liabilities. The financial panic of 2008 reminded bankers that they also can face liability and capital adequacy risks if financial markets become less liquid or seize up completely (trading is greatly reduced or completely stops.
1. A balance sheet is a financial statement that lists what a company owns (its assets or uses of funds) and what it owes (its liabilities or sources of funds).
2. Major bank assets include reserves, secondary reserves, loans, and other assets.
3. Major bank liabilities include deposits, borrowings, and shareholder equity.
Author: Tillas Gopoza is an Economist. He writes in his capacity as the Chief Economist for the Bankers Association of Zimbabwe. He can be contacted at tillas@baz.org.zw