Chapter 17
Banking and the Management
of Financial Institutions
The Bank Balance Sheet
Liabilities
Assets
Basic Banking
General Principles of Bank Management
Liquidity Management and the Role of Reserves
Asset Management
Liability Management
Capital Adequacy Management
The Practicing Manager: Strategies for Managing Bank Capital
Case: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis
Off-Balance-Sheet Activities
Loan Sales
Generation of Fee Income
Trading Activities and Risk Management Techniques
Conflicts of Interest Box: Barings, Daiwa, Sumitomo, and Societé Generale: Rogue Traders and
the Principal-Agent Problem
Measuring Bank Performance
Bank’s Income Statement
Measures of Bank Performance
Recent Trends in Bank Performance Measures
◼ Overview and Teaching Tips
Although this chapter performs the conventional function of outlining what banks (depository institutions)
do, and what their balance sheets and income statements look like, it also emphasizes an analytic way of
thinking about how banks manage their assets and liabilities to make a profit. Two tools are used throughout
this chapter and the rest of the book—T-accounts and the analysis of the determinants of asset demand,
developed in Chapter 4. In teaching this material, it is worth emphasizing to the student that mastery of
these two tools will pay high dividends in helping them to learn (and perform well on exams) in this course.
Another point to emphasize is that the principles discussed here for bank management also apply to many
other financial institutions as well.
Chapter 17: Banking and the Management of Financial Institutions 99
The first three sections of the chapter—“The Bank Balance Sheet,” “Basic Banking,” and “General
Principles of Bank Management”—place particular emphasis on the question of why banks hold excess
reserves, since banks’ decisions about the amount of excess reserves they hold play an important role in
the money supply process.
The subsection, “Capital Adequacy Management,” and the following section, “Off-Balance-Sheet
Activities,” discuss issues which have become increasingly important in recent years. Many instructors
may therefore want to include this material in their course, yet none of this material is essential to
understanding later chapters, so it can be skipped without any loss of continuity. The Practicing Manager
application on strategies for managing bank capital illustrates how managers deal with an important
managerial issue, while the case on the credit crunch in 2008 particularly piques the interest of students
because it shows how changes in banks’ behavior can have major effects on the economy.
◼ Answers to End-of-Chapter Questions
2. No, because the bank president is not managing the bank well. The fact that the bank has never incurred
3. No. When you turn a customer down, you may lose that customer’s business forever, which is
4. Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan
5. You should want to make short-term loans. Then, when these loans mature, you will be able to make
loans at higher interest rates, which will generate more income for the bank.
6. False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher
7. True. Banks can now pursue new loan business much more aggressively than in the past because when
9. Interest expenses have large fluctuations because interest rates fluctuate so much; provisions for loan
Chapter 17: Banking and the Management of Financial Institutions 101
Copyright © 2015 Pearson Education, Inc.
After 36 months, the mortgage balance is:
PMT = $1,079.81, I = 7.8/12, N = 324, FV = 0
Compute PV. PV = $145,764.43
However, at current rates, the remaining cash flows are worth:
PMT = $1,079.81, I = 13/12, N = 324, FV = 0
Compute PV. PV = $96,637.64
Wiggley S&L expects to take a loss of $49,126 if it sells the mortgage.
4. Refer to the previous question. In 1981 Congress allowed S&Ls to sell mortgages at a loss and to
amortize the loss over the remaining life of the mortgage. If this were used for the previous question,
how would the transaction have been recorded? What would be the annual adjustment? When would
that end?
Solution: The sale would be recorded as:
Debit
Credit
Cash
$96,638
Mortgage
$145,764
Capitalized Loss
$49,126
Then, each year for the next 27 years (ending in 2007!), the loss would be written off:
Credit
Loss Expense
$1,819.48
Capitalized Loss
$1,819.48
5. For the upcoming week, Nobel National Bank plans to issue $25 million in mortgages and purchase
$100 million 31-day T-bills. New deposits of $35 million are expected, and other sources will
generate $15 million in cash. What is Nobel’s estimate of funds needed?
6. A bank with $100 million in demand deposits estimates that net daily deposits are, on average,
$100 million with a standard deviation of $5 million. The bank wants to maintain a minimum of 8%
of deposits in reserves at all times. What is the highest expected level of deposits during the month?
What reserves do they need to maintain? Use a 99% confidence level.
Solution: The highest that demand deposits will reach, with 99% confidence, is $100 M + 3
7. NewBank started its first day of operations with $6 million in capital. $100 million in checkable
deposits is received. The bank issues a $25 million commercial loan and another $25 million in
mortgages, with the following terms:
102 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
• commercial loan: 3-year loan, simple interest paid monthly at 0.75%/month.
If required reserves are 8%, what does the bank balance sheets look like? Ignore any loan
loss reserves.
Assets
Liabilities
Required Reserves
$ 8 million
Checkable Deposits
$100 million
Excess Reserves
$48 million
Bank Capital
$ 6 million
Loans
$50 million
8. NewBank decides to invest $45 million in 30-day T-bills. The T-bills are currently trading at $4,986.70
(including commissions) for a $5,000 face value instrument. How many do they purchase? What does
the balance sheet look like?
Solution: The bank can purchase $45 M/$4,986.70, which is about 9,024 T-bills. The actual cost is
$44,999,980.80.
After the transaction, the balance sheet is:
Assets
Liabilities
Required Reserves
$ 8 million
Checkable Deposits
$100 million
Excess Reserves
$ 3 million
Bank Capital
$ 6 million
T-bills
$45 million
Loans
$50 million
9. On the 3rd day of operations, deposits fall by $5 million. What does the balance sheet look like? Are
there any problems?
Solution: The cash leaving the bank comes from reserves, first excess and then required. Following
the outflow, the balance sheet is:
Assets
Liabilities
Required Reserves
$ 6 million
Checkable Deposits
$95 million
T-bills
$45 million
Bank Capital
$ 6 million
Loans
$50 million
With $95 million in deposits, the 0.08 $95 M is required in reserves, or $7.6 million.
The bank is short $1.6 million.
10. To meet any shortfall in the previous question, NewBank will borrow the cash in the fed funds market.
Management decides to borrow the needed funds for the remainder of the month (now 29 days). The
required yield on a discount basis is 2.9%. What does the balance sheet look like after this
transaction?
Solution:
Assets
Liabilities
Required Reserves
$7.6 million
Checkable Deposits
$ 95 million
T-bills
$ 45 million
Fed Funds Borrowed
$1.6 million
Loans
$ 50 million
Bank Capital
$ 6 million