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Securities with high returns and low risk lower risk

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Unformatted text preview: risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets Eco 029 Chapter 10, Chapter 14 Liability Management Recent phenomenon due to rise of money center banks Expansion of overnight loan markets and new nancial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as source of bank funds Eco 029 Chapter 10, Chapter 14 Capital Adequacy Management Bank capital helps prevent bank failure The amount of capital aects return for the owners (equity holders) of the bank Regulatory requirement Eco 029 Chapter 10, Chapter 14 Preventing Bank Failure Capital Adequacy Management: Returns to Equity Holders Return on assets (ROA): net prot after taxes per dollar of assets ROA = net profit after taxes assets Return on equity (ROE): net prot after taxes per dollar of equity capital ROE = net profit after taxes equity capital Link between ROA and ROE: equity multiplier The amount of assets [er dollar of equity capital Equity Multiplier ROA = net profit after taxes assets ROE = net profit after taxes equity capital EM = net profit after taxes equity capital = Assets equity capital net profit after taxes assets Assets × equity capital ROE = ROA × EM Capital Adequacy Management: Safety Benets the owners of a bank by making their investment safe Costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy and levels of condence Application: How a Capital Crunch Caused a Credit Crunch Shortfalls of bank capital led to slower credit growth Huge losses for banks from their holdings of securities backed by residential mortgages. Losses reduced bank capital Banks could not raise much capital on a weak economy, and had to tighten their lending standards and reduce lending. Managing Credit Risk Screening and Monitoring Screening Specialization in lending Monitoring and enforcement of restrictive covenants Managing Credit Risk Long-term customer relationships Loan commitments Collateral and compensating balances Credit rationing Managing Interest-Rate Risk If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank prots and a decline in interest rates will raise bank prots Gap and Duration Analysis Basic gap analysis: (rate sensitive assets-rate sensitive liabilities) ×∆interest rates=∆in bank prot Maturity bucked approach Measures the gap for several maturity subintervals. Standardized gap analysi...
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