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BANK MANAGEMENT AND PROFITABILITY CHAPTER OBJECTIVE 1. The last chapter examined commercial bank operations by looking at the balance sheet. This chapter examines the income statement. 2. The chapter describes bank management strategy in terms of tradeoffs between safety (solvency and liquidity) and profitability. 3. The chapter summarizes the ways in which banks either choose or are compelled to manage liquidity, capital, credit risk, and interest rate risk. A recurring theme is the different choices available to small banks and large banks. CHANGES FROM THE LAST EDITION All tables and exhibits have been updated. CHAPTER KEY POINTS 1. Bank management must balance profitability, liquidity, and solvency to satisfy each of 3 constituencies: shareholders, depositors, and regulators. This dilemma is the central theme of bank management. Each risk managed by banks has material implications for each constituency. 2. Liquidity management is essentially a constraint optimization exercise. Analyze liquidity from a sources and uses perspective, implicating both sides of the balance sheet. Asset categories are key: Primary reserves are highly liquid but earn little, while various loan and investment categories have less liquidity. Liability management does not supersede asset management and is more a tool of large banks that have direct access to the money markets. 3. Capital management as a balance between solvency and profitability. The main themes in capital management are definition of the two tiers, risk-weighting of assets, conversion factors for off-balance- sheet items, and minimum capital ratios. 4. Credit risk is both a transactional issue and a portfolio issue. Credit risk may be effectively managed through prudent loan approval practices, systematic identification of problem loans, adequate loan loss reserves, and portfolio diversification, both industrial and geographical. 5. Modern banks must measure and manage interest rate risk. When maturities or cash flows are “gapped”, changes in market interest rates affect the cash flow, earnings, and equity value of the bank. Matching maturities alone does not hedge the bank: Most assets and liabilities have varied cash flow patterns. Matching durations, while operationally difficult, is a better way to manage interest rate risk. Students should not confuse maturity GAP with duration GAP and should, in fact, understand their “opposite sign” relationship: A positive maturity gap sets up the same exposure to a given change in rates as a negative duration gap, and vice versa. The depth of coverage to give the various hedging techniques depends on whether Chapter 11 has, in fact, been covered before the Institutions material. ANSWERS TO END-OF-CHAPTER QUESTIONS
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