Chapter 9: Bank Management
The author begins with a simplified description of the balance sheet for those who have never seen one. It's a pretty good description: all of the company's assets (cash, equipment, real estate, collectibles) are listed in one column and its liabilities (bills/payments it owes to others) are listed in a second. The difference between the two is the "equity" - what the company would be worth if it sold off all its assets and paid off all its debts. Equity is usually listed beneath liabilities in the second column, such that the total of the two columns add up to the same number.
Ledgering Assets and Liabilities
Then, there is a similar description of the ledgering process of double-entry accounting, in which any transaction is reflected by multiple ledger entries that also balance out. For example, when a retailer buys inventory on credit, the amount of the purchase increases his inventory (asset) and increases his accounts payable (liability) by the same amount.; and when he pays the bill, it reduces his cash (asset) and reduces his accounts payable (liability) by the same amount. There are also instances where the entry affects only one side of the balance sheet: if the retailer bought the inventory for cash, then it would increase his inventory (asset) and decrease his cash (asset) by the same amount.
Most investment activities are a trade of one asset for another and affect only one side of the balance sheet. When a bank extends a loan, it decreases its cash (asset) but increases its collectibles (asset) by the same amount. But when it collects a payment, there is a triple-entry, because the receipt of payment increases its cash (asset), decreases its collectibles by the amount of principle repaid (asset), and increases its equity by the amount of interest it has collected (equity is in the liabilities column).
When transactions are leveraged (money is borrowed to be invested), the transactions shift the numbers around. The loan of money increases cash (asset) and increases accounts payable (liability) and its reinvestment decreases cash (asset) and increases accounts collectible (liability). The net result is an increase in accounts receivable (asset) and payable (liability) through the medium of the cash borrowed, which is swept from one to the other as the funds are received and dispensed.
Much of the management of financial firms consists of exactly those kinds of maneuvers, seeking to shift money to the accounts in which it generates a profit while retaining enough money for the firm to remain creditworthy enough to borrow more money to invest.
Ultimately, the goal of financial management is to maintain and increase the firm's equity, as this reflects the net worth of the organization. Both investors and regulators keep a close eye on the manner in which the firm's equity is managed, and regulators will often step in to prevent the failure of the organization (or behalf of its owners) if its equity seems to be plummeting. However, in the age of electronic commerce, equity can plummet very rapidly - there is not the delay of ink-and-paper contracts and the movement of physical money that caused banking to move at a more moderate pace in the past.
Bank Management Principles
The author suggests some basic principles for managing a bank operation:
- Asset Management - The bank must lend out capital to earn profit and cover expenses
- Liquidity Management - The bank must retain enough capital to satisfy depositors' demands for withdrawals
- Capital Adequacy Management - The bank must retain sufficient net worth to provide a buffer against bankruptcy
- Liability Management - When the bank borrows funds to loan, it must do so as cheaply as possible
And a few basic points of profitability:
- A bank earns profit on the difference between what it pays for capital and the interest it charges to lend it
- The bank faces credit risk, which is the risk borrowers will not repay their loans
- The bank faces interest rate risk, which is the risk that the short-term interest rate it must pay for capital may exceed the long-term rate it charges on loans it has already extended.
Diversity is the method by which a bank manages risk. A bank that is not sufficiently diversified finds that it faces extreme risk when one sector of the economy falters. For example, a bank that lends exclusively to soybean farmers in a very limited geographic area will be in serious trouble if there is a flood in that area that destroys the crops because all its debtors will be rendered unable to repay. It would be wiser to loan to farmers who have different crops (and to non-farming businesses) and who are in a variety of geographic locations so that a catastrophic event in one area only affects a small percentage of its borrowers.
He then channel-surfs to the topic of reserves: the bank must maintain enough cash to pay depositors' demands to withdraw it, but is at the same time interested in having as much capital loaned out and earning interest. Failure to maintain adequate reserves has historically been the primary cause of bankruptcy, which has been addressed somewhat by federal insurance (FDIC) that discourages customers from panicking and a required amount of reserve mandated in order to maintain that insurance.
It's also suggested that, historically, bankers were not very active in managing their business. Up until the 1960s, banks were largely landlocked and could count on having the business of customers in their geographic areas (there was only one bank in a given town) and were able to flex their liability (interest paid to depositors) according to the interest they were earning on loans. But as customers and money became more mobile, depositors had a choice of banks and would flock to banks that paid better interest, so banks had to become more aggressive in attracting both depositors and borrowers by offering better rates to both, squeezing their profit margin. In the 1990s, there was further deregulation to enable banks to better manage/invest their capital and involve themselves in other lines of business to generate profit.
Corporate banks can also use their stock to manage capital reserves - buying or selling their own shares to the open market to decrease or increase its capital. And banks that pay dividends to shareholders can likewise manage the bank's capital by deciding how much (or little) to dispense to shareholders versus the amount retained to be used as capital.
Managing Credit Risk
The author returns to credit risk because it is the most basic and fundamental: even if every other aspect of the business is managed perfectly, the bank cannot survive if it does not manage its credit risk and keep defaults to a minimum.
Credit risk management begins with applicant screening: gathering as much information about applicants as possible (direct questioning, third-party reports, audits, and investigations) to accurately assess a borrower's ability to repay. Investigation and validation is particularly important because uncreditworthy applicants realize that they will be rejected and will misrepresent themselves to obtain credit. (EN: It's also noted that uncreditworthy people are such because they are bad with handling money, hence are always in need of more.) An insurance company can simply refuse to pay a claim if an applicant misrepresents the value of his property, but for a bank, its capital has already left its possession when a loan is funded, so their risk is greater.
Commercial banks also tend to specialize, which runs counter to the principle of diversification, but is often beneficial to assessing credit risk. A bank that lends only to soybean farmers or textile manufacturers can become very knowledgeable about that line of business and can expertly assess whether a borrower's operations are sustainable. Specialized banks also tend to forge more long-term relationships with their customers, and a close relationship both discourages fraud and provides better means to detect when a customer might be in financial trouble. The net result of a relationship, though, tends to be that banks become more liberal in their lending to regular customers.
Another way to mitigate credit risk is to insist on collateral - assets that the bank is legally entitled to seize if the borrower defaults, so that the bank can sell those assets to recover a portion of its capital. This is quite common in mortgage and auto loans for the bank to be able to seize the property that was purchased with borrowed funds, but this direct connection is not necessary: a borrower could put up their jewelry or art collection as security for a loan that is used for any purpose they please - but in general, the collateral is almost always worth less than the loan, so banks take a loss when borrowers default, just not as much of one.
And finally, a bank decides the level of risk it is willing to accept: some banks refuse to loan to any but the most creditworthy applicants, others seem willing to take on anyone. The riskier the borrower, the greater the reward for lending to them, but the greater the default risk the bank takes on by underwriting those loans.
The author mentions the global financial meltdown of the early twenty-first century being caused by banks issuing mortgage loans to extremely unqualified applicants, but concedes that there was a great deal of political pressure. Instead of guiding banks to be conservative in their lending, the federal government encouraged reckless lending and even provided mechanisms and facilities for banks to be able to loan money with wild abandon - and when those unqualified borrowers defaulted (as common sense would indicate they inevitably would), the loss was passed from hand to hand through a labyrinth of securitized debt instruments. But fundamentally, it was a problem of credit risk management: loaning money to those who can't repay it is never a good idea.
Interest-Rate Risk
To be clear, banks are not at risk because of the interest rate, but because the interest rate may change. A bank that takes a ten-year loan at 3% and lends the money at 5% will make a 2% return over the course of those ten years, provided the borrower does not default. The problem arises when the bank uses short-term borrowing to fund long-term lending: the bank borrows money at a variable rate to finance a fixed-rate loan - and if the rate on its borrowings exceeds the rate at which it has lent the money, the bank takes a loss.
In some instances, the interest rate on a given source of capital is variable: the rate paid on a savings account or an adjustable-rate CD will immediately respond to changes in the market rate. In other instances, the bank may have fixed-rate sources, but changes in the sources cause the rate to vary in aggregate. For example, the bank that has borrowed at 3% to fund loans may find itself short of capital and must take additional debt at a higher rate to satisfy its obligations, which raises the aggregate rate of the bank's entire pool of capital.
If interest rates were stable, banks would not face this risk - they could always count on borrowing more money at the same rate as they had borrowed it in the past. The Federal Reserve attempts to moderate changes in interest rates (and in the present day to keep them at a low rate for an extended period of time) by managing the money supply. Since the interest rate is dependent on the supply and demand of money, the FR can alter the money supply (releasing more or less cash) to counter the movements of the market. (EN: Debasement of the currency, resulting in price inflation, resulting in greater demand for money, resulting in increased interest rates, resulting in more money being supplied, resulting in more debasement, etc. is a disastrous feedback loop that has not yet occurred, but remains possible.)
While the dark side of interest rate risk is usually the focus, there is also the potential for a bank to profit by falling interest rates because customers who have committed to paying high-interest loans provide a rich return on capital that can be cheaply borrowed. It is generally expected that customers will refinance to a lower rate when the interest rate falls, but it can be observed that customers are very slow to react - particularly the unsophisticated borrowers who hold consumer loans may simply be resigned to making their usual car payment rather than refinancing when the credit rate drops, so banks can earn a windfall profit.
Off the Balance Sheet
There are many activities in which banks engage that do not result in a change to the figures on their balance sheets. While the phrase "off the balance sheet" implies that these are clandestine and unethical activities, this is not the case: Most of these activities are entirely legal, ethical, and commonplace.
One common example is refinancing debt to a more advantageous rate of interest. When the bank sells a low-interest loan and uses the proceeds to extend a higher-interest loan in the same dollar amount, there is no change to its accounts payable - the same amount is outstanding to be collected, just at a higher rate when payments come in. Likewise, when the bank refinances its own lending, its payables do not change but its future cash flow will be improved.
Another example is in the implementation or increase in banking fees. Most retail banking customers are aware of an irritated by the panoply of fees that banks charge for services such as stopping payment on a check, using an ATM, and so on. But there are also more significant fees charged to commercial customers, such as loan guarantees, backup lines of credit, and foreign exchange transactions. Because fees affect future receipts and not current assets or liabilities, they do not cause a stir on the balance sheets.
Because of deregulation, banks are also free to invest their assets in a broader variety of investment vehicles. They commonly traded treasury notes, bonds, and commercial paper to manage their cash flows, but are now free to play in the stock and derivatives markets. Again, the total value of its investment portfolio does not change when a bank changes its investments, but the future performance of those investments will affect the bank's profits.
There is also the common practice of interest-rate swaps, in which two financial institutions essentially loan each other money at different interest rates. While this seems confounding, it is generally a matter of risk management: the bank that is initially getting the better deal is betting that interest rates will not fluctuate in a way that would make the exchange disadvantageous for them, whereas the bank that is getting the worse deal is betting that interest rates will fluctuate, and they will be better off if their predictions come to pass. This practice is most dangerous when it crosses national borders, as a bank is betting on both the interest rate and currency stability of another nation - and if both fluctuate, one participant will make a tremendous profit while the other will take a tremendous loss.