Class 10 - Econ 350 U.S. Financial Systems, Markets and...

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U.S. Financial Systems, Markets and Institutions Class 10 Econ 350 U.S. Financial Systems, Markets, and Institutions Class 10: Principles of banking management In this morning’s class, we analyze the juggling act that most bank managers have to perform in trying to satisfying competing interests. A banker should make safe loans yet earn a high rate of return; a banker must provide both liquidity and profitability; and a banker must satisfy the demands of both regulators and stockholders. As we will see, the art of banking is a constant process of balancing the conflicting goals of risk and return. Course Objectives After today’s class, you should - know the basic principles of banking management. - understand the competing goals that must be satisfied by a bank manager. - know the concepts of Return on Equity and Return on Assets. - appreciate the problems of credit risk and interest rate risk faced by bank managers. - become familiar with Gap Analysis and Duration Analysis. Principles of Banking Management In general, a bank manager must be concerned with a myriad of issues. First of all, she wants to maximize profit. This occurs by achieving a high rate of return on assets by managing credit risk, or the possibility that a loan may default. Also she must be aware of interest rate risk, or that changes in interest rates will change the value of some assets and liabilities held by the bank. Once the manager is able to control interest rate risk and credit risk, then the potential for financial success is greatly increased. Specifically, we can identify four major areas of concern for bank management: 1. Liquidity Management: Above all else, a bank must have enough cash on hand to meet the demands of depositors. There must be enough vault cash to cover any deposit outflow. 2. Asset Management: A bank must pursue a low level of risk on its assets. It tries to minimize the risk of default on its loans and other assets. 3. Liability Management: A bank must acquire funds at a low cost. 4. Capital Adequacy Management: A bank must determine and acquire an adequate amount of capital to meet regulatory and liquidity needs. Recently, regulators have turned their attention to a different form of assessing safety and soundness known as Asset-Liability Management (ALM). In ALM, bank management matches the maturity and amounts of assets with the maturities and amounts of liabilities to minimize the bank’s exposure to interest rate risk. Also, credit risk can be controlled through diversification and the monitoring of loans. In all of these cases, the manager is balancing the needs of minimizing risk with the needs of maximizing return. We now turn our attention to the four principles of banking management listed above. 83
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This note was uploaded on 05/09/2009 for the course ECON 350 taught by Professor Christianson during the Spring '08 term at Binghamton University.

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Class 10 - Econ 350 U.S. Financial Systems, Markets and...

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