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MCF 304: Bank Management

Lecture 2.2

Asset Management

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Asset Management

• How to distribute bank funds among different categories of assets so as to maximize profits

• Different assets have different level of liquidity and profitability

• The LP dilemma: If bank emphasize on liquidity, profitability will be sacrifice

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Bank Financial Statements:Balance Sheet

Fixed Assets

Current Assets

- Cash and short term funds

- Securities purchased under resale agreement (REPO)

- Deposits and placements with banks and other financial institutions

- Securities held for trading

- Investment securities

- Loans, advances and financing

- Other assets

- Investment in subsidiary companies

- Investment in associate companies

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Bank Financial Statements:Income Statement

Interest Income

(-) Interest Expense

(=)Net Interest Income

(-) Allowance for losses on loans, advances and financing

(+)Non-Interest Income

(=)Net Income

Net Income

(-) Overhead Expenses

(=) Profit Before Tax

(-) Tax

(=) Net Profit After Tax

(-) Transfer to Statutory Reserves

(=) Net Profit After Transfer to Statutory Reserves

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Bank Financial Statements:Income Statement

Net Profit After Transfer to Statutory Reserves

(+) Retained Profit Brought Forward

(+) Distributable Profit

(-) Proposed Dividend

(=) Retained Profit Carried Forward

Earnings Per Share

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Asset Management

• How the bank invest its assets / funds to maximize its shareholders wealth

• As the liquidity and profitability differ from one assets to another, banks must take into consideration the liquidity-profitability (LP) Dilemma

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LP Dilemma

• Exist because the degrees of liquidity and profitability are different across different assets

• Attributed by conflicting goals among depositors, shareholders and controlling party

• Shareholders expect high return, depositors desire maximum liquidity

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LP Dilemma

• LP Dilemma = to find a method that can strike a balance between risk & return, liquidity & profitability

• Three methods;

i. Fund pool method

ii. Assets allocation method

iii. Management science method

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Fund Pool Method

• Fund from all sources are pooled together to create a single source of funds

• The funds are distributed to the various predetermined categories of assets based of their degree of importance

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Fund Pool Method

Example

Current deposits 200

Savings deposits 100

Fixed deposits 100

REPO 50

NCD’s 50

Debentures 100

Total 600

Reserve based 20%

Statutory reserves 10%

Secondary reserves 20%

Loan portfolio 30%

Allocation by sectors;

Agriculture 10%

Manufacturing 50%

Real estate 20%

Service 20%

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Disadvantaged of Fund Pool Method

• Over emphasize on liquidity at the expense of profitability

• Does not provide any specific basis for purpose of estimating liquidity standards

• does not take into consideration the volatility of deposits accounts

• Does not recognized source of liquidity

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Assets Allocation Method

• Banks are forced to utilize deposits more efficiently and effectively as a result of competition from non-bank financial institutions in terms of deposits acquisitions and use funds in a more profitable way

• Assets allocation method treats each source of fund individually in view of the different degrees of volatility among them. Each source of funds is treated as a profit centre

• Short (long) term assets should be financed by short (long) term financing

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Disadvantages of Assets Allocation Method

• May overestimate the liquidity of deposits accounts• Does not recognized loan portfolio as a source of

liquidity• Asset & liability management decisions are made

separately• does not provide specific guidelines on the allocation

of funds among different categories of bank assets

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Management Science Method

• a.k.a Linear programming method• A mathematical procedure to choose variable

values for purpose of maximizing (minimizing) an objective, subject to certain restrictions

• Helps to determine the required balance sheet quantity set in order to maximize bank profitability subjects to restrictions in trems of liquidity and other fixed rules

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Management Science Method

ExampleBank A has funds totaling RM25 million which can be invested in loan assets (X1) and secondary reserves (X2). The funds made up of current deposits and fixed deposits. The rate of return is estimated at 12% while short term securities 8%. Let’s assume that the bank income is net income after deducting the cost of deposits. The management bank of bank A has stipulated the bank’s liquidity standard of RM2 in short term securities for every RM10 investment in fixed assets

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Bank Liquidity

• 5 factors why banks must have adequate liquidity;

i. Confidence

ii. Relationship

iii. Force sale

iv. Risk premium

v. Last chance

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Bank Liquidity Theory

Commercial Financing- A bank is considered

liquid if its loan portfolio consist of short term financing only

- Maturity dates of financing coincides with maturity dates of deposits

Stability- Bank invest part of their

funds in loan portfolio & secondary markets

- This theory prolongs the average maturity period of loans portfolios

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Bank Liquidity Theory

Expected Income

- Bank liquidity can be acquired through loan repayments

- Loan repayment should be match with loan income

- Acknowledges that loan portfolio is a source of liquidity

Liability Management

- Banks can fulfill liquidity requirements by borrowing from the money and capital markets

- Borrowed funds acquired for the purpose of bank liquidity are sometimes called purchased funds

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Liquidity Measurement

• No one single specific measurement standards

• However loan to deposit ratio is used widely to measure liquidity

• As the ratio increases, bank liquidity decreases

• Loan interest increase in tandem with the increase in loan to deposit ratio since the demand for credit exceeds supply

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Disadvantages of Loan to Deposits Ratio

• Does not show the maturity or quality of loan portfolio

• Does not provide any truth about bank liquidity needs. Banks that provides more for speculative loans are more likely to face liquidity problems

• Does not provide any information on other assets of a bank other than its loan portfolio

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Other Liquidity Measurement

1. Cash Assets / Total Assets

2. (Cash Assets – Statutory Reserve + Marketable Government Securities of Less than One year Maturity) / Total Deposits

3. (Cash Assets – Reserve + Government Securities) / Total Deposits

4. (Cash Assets + Government Securities) / Total Deposits

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Estimating Credit Requirement

Please refer to worksheet

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Thank You!Izdihar Baharin @ Md Daud

Post Graduate CentreHP: 006019-5170817

Email: izdi@oum.edu.my