1301923372402_Chapter12_Instructor_Notes - CHAPTER 12:...

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______________________________________________________________________________________ 234 CHAPTER 12: DEPOSITORY INSTITUTIONS: BANKS AND BANK MANAGEMENT A. T HE B ASICS Core Principles 1, 2 and 3 underpin nearly all the discussion in chapter 12. In particular, the banker selects assets and liabilities consistent with obtaining maximum expected returns for a given amount of risk, or, equivalently, minimizing risk for a given expected return. In order to do this, the banker has absorbed the lessons of chapter 5 on how to compute expected returns on assets, along with how to measure the risk on those assets. Of course, expected return and risk are concepts associated with Core Principles 1 and 2. In addition, as you learned in chapter 11, there are important information problems for the banker to solve in the selection of assets (Core Principle 3), such as whether a particular borrower in line at the loan officer’s desk represents an adverse selection problem and whether there will be a moral hazard problem if the loan is granted. Chapter 12 takes as given your understanding of these issues and illustrates how the balance sheet of the bank looks once all the analysis of expected returns and risk has been completed. Assets and liabilities have been selected that produce appropriate diversification, and returns appropriate for the chosen risk level. So, as you investigate the balance sheet of a given bank, all the assets and liabilities are there for a reason. Once the balance sheet is explained, the sources of risk to the balance sheet itself are discussed. Some of these risks are familiar, such as credit risk, which results from borrowers failing to repay loans on schedule. Other risks arise for other reasons. For example, some risks come from the national or international economies, such as interest rate risk or exchange rate risk. And some comes from the way some banks operate, in the form of trading risk, which arises when the bank trades “for its own account.” B. S OLIDIFY Y OUR K NOWLEDGE DISCUSSION/EXTENSIONS OF THE BASICS A Simple Way to Think About Bank Management : The balance sheet “identity” or definition is that Total Bank Assets = Total Bank Liabilities + Bank Capital. Assets represent the uses of funds by banks, and most of them are held because they allow the bank to earn interest income, such as loans. Liabilities and bank capital represent the bank’s sources of funds. To attract these funds, the bank must pay interest, such as the interest rate on your savings account. At least from the perspective of the
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Chapter 12: Depository Institutions: Banks and Bank Management 235 balance sheet, for a bank to earn a profit, it must generally earn higher interest on its assets than it pays on its liabilities. So, suppose for a moment that all assets earn the same interest rate, i A. Also, suppose that the bank pays the same interest rate on all liabilities,
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This note was uploaded on 09/07/2011 for the course ECO 412 taught by Professor Staff during the Spring '05 term at Kentucky.

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1301923372402_Chapter12_Instructor_Notes - CHAPTER 12:...

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