The main focus of our policy makers, financial
managers and researchers, has attributed bank's activities as primary
channels through which monetary and financial policy is conducted.
Bank's behavioural response to shifting economic situations may
sometimes be intriguing. How the bank responds to tight and easy money,
to heavy loan-demand pressures, to Macroeconomic demands, to fluctuating
interests rates and the like situations may involve complex decision
making. How a bank in these circumstances utilizes its available funds
— its various amounts of capital, liabilities and assets through the
vehicle of its short-run and long-run banking management principles:
that is what this column is about.
Looking at the modern monetary system, we can
identify three sets of monetary institutions: the Treasury, the Federal
Reserve System and the Commercial Banks. The word "commercial"
is of course a throwback to the so-called commercial loan theory of
banking that held sway during the 19th century. The term commercial, in
contemporary banking appears self-contradictory because first —
commercial banks are no longer the exclusive suppliers of credit for
financing short-term business needs, second — these banks hold many
long-term assets, including long-term loans to businesses and
governments. The term commercial therefore could be misleading to
students of banking and to regulatory authorities as well. Nevertheless,
by the force of the banking tradition the term is still widely used, to
differentiate it from other financial institutions.
Commercial banks now operate in the financial
services industry (FSI) and not just in the narrowly defined banking
industry, reigning as the kingpins of FSI . Because of its importance in
regulating and functioning of the economy, commercial banking is today a
highly regulated business system. Despite emergence of a variety of
depository and monetary institutions, the overwhelming bulk of
third-party transfer, all forms of checking accounts (chequing here
having its American banking spelling) are handled by commercial banks.
In consequence, commercial banks are by far, the major institutions
responsible for a modern country's payment mechanism.
After having gone through the diversity of bank's
institutional arrangements, the concepts and practices of modern
commercial banks, their role in country's payment system, let us now
examine the mechanism and challenges of commercial banks management
Nevertheless, the thrust of my argument in this
discussion, would be to present a financial management framework for
bank's decision making in its short-run operational behaviour. A bank in
the long-run, requires funds from its liability and capital accounts and
then uses these to make loans and purchase investments. The bank's
profit like those of other businesses comes from the spread between its
costs and resources, in other words the cost of acquiring funds the
return on assets. The bank being primarily a profit-seeking institution,
its long-run concept is simply to maximize its long-run profits and
growth. Its short-run motive, though at times varied, complicated and
diversified, the bank's management generally seeks some optimum
combination of Earnings, Liquidity and Safety. And to secure more of
one, the bank must often sacrifice some of the others. For example, to
get higher earnings it must have to incur more risk and illiquidity; and
to get more safety and Liquidity, it may have to scarifice some
earnings. The bank may face uncertainties and risk of many kinds.'
A bank according to Dudley G Lukett may be compared
to a "pumping station" on a pipeline through which money is
flowing . Money flows into the bank when customers add to their
deposits, when outstanding loans come due and are repaid, when bank
sells certificates of deposits etc on the market.
Money is pumped out of the bank, when customers
withdraw their deposits, when the banks make new loans when its
scheduled liabilities i.e C.D. come due, and the like . Thus the bank in
its day-today operation has to "recycle" all the money moving
It is important here to distinguish between the banks
Controllable and Uncontrollable items in the bank's balance sheet, in
order to get a clearer picture of the bank's short-run operational
behaviour . The bank's uncontrollable balance sheet elements may mean
those items over which the bank has little control — which include
deposits, (including time — and savings deposits — time deposit
being classified in two categories — Consumer Type and Business Type),
loans, cash items in the process of collection i.e cheques that are in
clearing process, short-run changes in the bank's capital account and
required reserves. On the contrary, controllable items are those over
which the bank has considerable short-run control. Controllable items
are of two types 1. Managed Liabilities 2. Secondary
Managed liabilities include a number of bank-related
money market interments that are issued by banks. They are 1.
Federal Funds 2. Large Certificates of Deposit 3.
Repurchase Agreements and 4. Euro-dollar borrowings etc . They
are called managed liabilities because they are money, the bank owes to
their customers and hence are liabilities and because the bank can
manage them by issuing them in larger or smaller amounts according to
the bank's needs .
Secondary reserve assets are a group of money market
intruments, which a bank may hold for its earning ability, but which may
be sold on a short notice if the bank needs to recover its money to uses
for other purposes (such as paying off the depositors or making loans).
These short term instruments are known for their liability and
marketability . Secondary reserves are not legal reserves and the bank
can hold them as much as it can. The money market intruments available
for banks to use as secondary assets are treasury bills, commercial
paper, banker's acceptances, federal funds sold (Lent), broker and
dealer loans and the like.
The process of short-run or day- today bank
management can be better understood in terms of the distinction between
the bank's controllable and uncontrollable behaviour. Each day the bank
experiences substantial amount of uncontrollable flows of funds moving
through it. Some of these fund flows, such as deposit increases, loan
repayments, and maturing investments are sources of bank funds.
Short-run banking management consists of making changes in its
controllable items to offset or reinforce the net effect of the
uncontrollable flows in order to achieve its certain short-run goals.
However, in making these changes in its controllable elements, the bank
has wide areas of choices open to it. For example, if the net effect of
the uncontrollable items is to use the bank's funds, the bank may offset
this by selling treasury bills ( T-Bills), by issuing negotiable CDs, by
purchasing federal funds etc.
Here comes the hard-core management problem — it is
this set of choices that constitutes the short-run problems of bank
management. Different banks would make different choices, depending on a
variety of circumstances. It may be appropriate here to explain some of
the underlying principles on which these management choices may be made.
The principles of short-run bank management involve these short-run bank
goals - 1. Legal Reserve Requirements 2. Taking Care of
Customer Needs and 3. Pursuing an Investment Strategy.
As regards bank's legal reserve management, if a bank
ends its legal reserve maintenance with its average reserve maintenance
being either larger or smaller than required, it may suffer a loss. An
equally important goal of the bank management is servicing customer
needs . The bank's investment strategy consists of determining the types
and amounts of various open market debt instruments that the bank wants
to hold as earning assets. The set of decisions is quite risky and
complex, depending on such factors as risk, tax status and the
comparative yields of various instruments available.
Finally the methodology of achieving bank's
goals:banks generally make decision of achieving their goals based on
their management philosophy, cost minimization principles and other
factors. Management philosophy consists of a set of explicit and
implicit guidelines laid down by top management that specify certain
constraints on the behaviour of different departments. Bank's different
management styles may be classified into an aggressive management
philosophy, a conservative management philosophy and a philosophy of
management falling in between these two extremes.
The Muslim Commercial Bank Limited the future pride
bank of Pakistan seems to be making a very heavy use of its secondary
reserve assets as the controllable element in its short-run adjustments
process . The reason that the use of secondary reserves is considered
conservative is that the bank is meeting its short-run goals through the
use of its internal resources of funds so that the bank does have to
borrow heavily from the market .
As regards Cost Minimizing Management, a bank
requiring additional loan funds for its customers, may acquire them in
many different ways 1. Purchasing federal funds 2.Issusing
large certificates of deposit 3.Entering into repurchase
agreements 4. Selling treasury bills, to name only a few . In
general terms, the particular intruments or combination of intruments
chosen by the bank to achieve its goal may conform to the least-cost
principle. Moreover the actual cost of a particular instrument will
often depend on what happens in the future . And since the bankers do
not know what the future holds for them they must base their decisions
on the EXPECTATIONS about the future . It is these expectations that
call for most of the skills of the banker and it is the consequences of
the banker's expectations that lead to two cost minimization principles
that would be considered - 1. Expectations about the length of
time for which additional loan funds are required and 2.
Expectations about the future course of interest rates.
The pure expectation theory ( PET) approach contends
that investors expectations of future short-term interest rates,
determine the slope of the yield curve . PET makes a number of
simplifying assumptions, the most important of which are 1.
Investors are profit maximizers, whose expectations are firm, uniform
and endless. 2. Perfect certainty includes accurate forecasts and
3. Zero transaction cost . Given these assumptions and the
investors holding-period, each investor selects the portfolio that
In view of the foregoing expectations theory and the
time for which additional loan funds are needed, let us suppose a bank
has a sudden increase in its loan demand for its customers (an
uncontrollable use of funds) with no corresponding increase in the
bank's uncontrollable sources . In such a situation, the bank for
example, has narrowed its choice down to two items 1. Negotiable
CDs or 2. Repurchase Agreement . Now the problem to be figured
out — on what basis will the bank choose between these two alternative
sources of loan funds?
The question as to what additional loan funds in the
form of CDs or Repurchase Agreement (REPO) can be chosen by the bank is
analyzed with the aid of the above figure. The figure shows total
cumulative (Rupee) cost on the vertical axis and the time on the
horizontal axis. In the above figure, the line slopped upward is
labelled Repurchased agreement and rises steadily the longer the time
over the funds are used . The line is slopped upward because repurchase
agreement (RPs or REPOS) as they are called are commonly renewed on a
daily basis with different customers .
Reverting to the choice between the two alternative
sources of providing additional loan funds to its customers, we again
refer to the above figure representing comparative costs etc for use of
either CDs or RPs by the bank .
To explain further, RPs require a great deal of paper
work. Thus the total cost of repurchase agreements are largely variable
costs, rising as a function of the length of time for which funds are
needed. Issusing CDs in contrast, involves the bank in high- fixed costs
including insurance premiums and non-earning reserves but no variable
costs. Once the CDs are issued, no further expenses are incurred.
The purpose of my having drawn the above figure is to
make the underlying assumptions — if the banker needs funds for a very
short period of time, he will minimize his costs by issuing repurchase
agreements, but if he needs funds for a longer period he will minimize
his cost by issuing CDs. However, this judgement is dependent on the
banker's pure expectations (PE) that is, the banker does not really know
with certainty how long the increased loan demand will last and the
expectations about the future course of interest rates.
Everything having been taken into account, it is
ultimately the banker's pure expectation and skill which make the most
of his banking opportunities or the bank's future marred by his error of
judgement. Moreover, a bank management capable of spotlighting
principles of value maximization (maximization of bank's equity value),
allocational efficiency, bank's liquidity, market limits, market pull
and the bank's long-range strategic planning — could provide a welcome
shot in the arm, for having chances of being Winners and Achieving
Dominance, and at the very least, of Surviving.