SEVENTH EDITION

BANK MANAGEMENT

TIMOTHY W. KOCH
UNIVERSITY OF SOUTH CAROLINA

S. SCOTT MACDONALD
SOUTHERN METHODIST UNIVERSITY

HOCHSCHULE
LIECHTENSTEIN
Bibliothek

*% SOUTH-WESTERN
i% CENGAGE Learning"

Australia"».Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
 Contents
Chapter 1 Banking and the Financial Services Industry 1
Credit Crisis of 2007-2009 2
How Do Banks Differ? 7
Organizational Structure and Financial Services Business Models 17
Different Channels for Delivering Banking Services 24
Summary '.'. 26_
Questions.... 26
Activities 27.
References 28

Chapter 2 Government Policies and Regulation ; 31

Historical Bank Regulation 32
Goals and Functions of Depository Institution Regulation 34
Ensure Safety and Soundness and Provide an Efficient and Competitive System .. 35
Maintaining Monetary Stability and the Integrity of the Payments System 47
Efficient and Competitive Financial System 52
Summary 64
Questions 65
Activities 66
References .....67

Chapter 3 Analyzing Bank Performance 69

Commercial Bank Financial Statements 71
The Relationship Between the Balance Sheet and Income Statement. 94
The Return on Equity Model 96
Managing Risk and Returns 107
Evaluating Bank Performance: An Application , 121
: Maximizing the Market Value of Bank Equity 135
Financial Statement Manipulation 140
Summary .-rr-. , 143
Questions ..,;..... 144
Problems 146
References 146
Appendix 150

Chapter 4 Managing Noninterest Income and Noninterest Expense 169

Noninterest Income 173
Noninterest Expense 179
Which Lines of Business and Customers Are Profitable ;, 185
Summary : 201
Questions 201
Activity .....202
References 203
Contents • \ XIII

Chapter 5 The Performance of Nontraditional Banking Companies 205

The Financial Performance of Goldman Sachs 206
The Financial Performance of Mutual of Omaha Bank 215
The Financial Performance of BMW Financial Services and
BMW Bank of North America „; 218
Summary 222
Questions ....223
Activities ; 223
References 224

Chapter 6 Pricing Fixed-Income Securities 225

The Mathematics of Interest Rates 226
Future Value and Present Value: Single Payment ...226
"Future Value and Present Value: Multiple Payments.. 229
Simple versus Compound Interest 230
The Relationship Between Interest Rates and Option-Free Bond Prices 232
Duration and Price Volatility ;. 238
Recent Innovations in the Valuation of Fixed-Income Securities and
Total Return Analysis 243
Money Market Yields 247
Summary... 251
Questions 252
Activities ". .....254
References..... , 255

Chapter 7 Managing Interest Rate Risk: GAP and Earnings Sensitivity......... 257
Measuring Interest Rate Risk with GAP.. 259
Earnings Sensitivity Analysis 278
Income Statement GAP 287
Managing the GAP and Earnings Sensitivity Risk... 289
Summary 290
Questions 291
Activities .• 293
References... ;... i 296

Chapter 8 Managing Interest Rate Risk: DuratioiTGap and Economic Value of Equity.. 297
Measuring Interest Rate Risk with Duration Gap 300
Economic Value of Equity Sensitivity Analysis..... „.. 310
Earnings Sensitivity Analysis versus EVE Sensitivity Analysis:
Which Model Is Better? 315
A Critique of Strategies for Managing Earnings and.Economic
Value of Equity Sensitivity ..317
Yield Curve Strategies ; , ;.... 320
Summary 321
1
Questions... , 322
Activity..., 324
References 324
xiv Contents

Chapter 9 Using Derivatives to Manage Interest Rate Risk 327

Characteristics of Financial Futures 328
Speculation versus Hedging 338
Microhedging Applications 347
Macrohedging Applications 351
Using Forward Rate Agreements to Manage Rate Risk 354
Basic Interest Rate Swaps as a Risk Management Tool 356
Interest Rate Caps and Floors ; 364
- Summary 377
Questions 378~
Activities 382
References 385

Chapter 10 Funding the Bank 387

The Relationship Between Liquidity Requirements, Cash, and Funding Sources. 389
Characteristics of Retail-Type Deposits 394
Characteristics of Large Wholesale Liabilities 405
Electronic Money : 419
Check 21 : 422
Measuring the Cost of Funds 427
The Average Historical Cost of Funds 427
Funding Sources and Banking Risks 435
Summary 438
Questions 439
Problems ..441
Activities 442
References 443

Chapter 11 Managing Liquidity 445

Meeting Liquidity Needs 447
Reserve Balances at the Federal Reserve Bank 451
Meeting Legal Reserve Requirements 456
' Liquidity Planning .464
Traditional Aggregate Measures of Liquidity Risk 471
Longer-Term Liquidity Planning^ 475
Contingency Funding ,481
Summary 482
Questions 483
Activity 485
References 485

Chapter 12 The Effective Use of Capital 487

Why Worry about Bank Capital? 488
Risk-Based Capital Standards 490
What Constitutes Bank Capital? 497
What Is the Function of Bank Capital?........ 503
How Much Capital Is Adequate? 507
The Effect of Capital Requirements on Bank Operating Policies 508
Contents . xv

Characteristics of External Capital Sources 512

Capital Planning 517
Depository Institution Capital Standards 520
Federal Deposit Insurance 522
Summary 527
Questions 528
Problems 529
References 531
Appendix 532

Chapter 13 Overview of Credit Policy and Loan Characteristics 541

Recent Trends in Loan Growth and Quality 542
Measuring Aggregate Asset Quality ; 553
Trends in Competition for Loan Business 555
The Credit Process 555
Characteristics of Different Types of Loans 565
Summary .' ..582
Questions... 582
Problems ,. 584
Activity •. 584
References . 585

Chapter 14 Evaluating Commercial Loan Requests and Managing Credit Risk 587
Fundamental Credit Issues 589
Evaluating Credit Requests: A Four-Part Process 594
Credit Analysis Application: Wade's Office Furniture 619
Managing Risk with Loan Sales and Credit Derivatives 634
Summary 640
Questions 640
Problems 643
References 646
Appendix 1 648
Appendix II .....651
Appendix III 653

Chapter 15 Evaluating Consumer Loans ..7. 655

Types of Consumer Loans 657
Subprime.Loans 666
Consumer Credit Regulations 668
Credit Analysis 677
Recent Risk and Return Characteristics of Consumer Loans 688
Summary 690
Questions 691
Problems..... 692
Activities 693
References 694
xvi Contents

Chapter 16 Managing the Investment Portfolio.. 697

Dealer Operations and the Securities Trading Account 699
Objectives of the Investment Portfolio 701
Composition of the Investment Portfolio 705
Characteristics of Taxable Securities ..707
Prepayment Risk on Mortgage-Backed Securities 719
Characteristics of Municipal Securities 730
Establishing Investment Policy Guidelines 736
Active Investment Strategies 737
The Impact of Interest Rates on the Value of Securities with
Embedded Options ....745
Comparative Yields on Taxable versus Tax-Exempt Securities 755
The Impact of the Tax Reform Act of 1986 761
Strategies Underlying Security Swaps 763
Summary 766
Questions 767
Problems...: 769
Activity 771
References .- 771

Chapter 17 Global Banking Activities 773

U.S. Depository Institutions in the World Market 773
Impact of the Credit Crisis of 2007-2008 777
The European Community 784
Universal Banking Model........ 786
Organizational Structure of U.S. Banks with Foreign Operations. 788
International Financial Markets 791
International Lending 794
Foreign Exchange Activities 800
Summary 805
Questions.. 806
References i 807

Glossary 809
Index r. 859