Profit is probably the dream of every banker, but can he make it happen by just following the complex banking management principles?


July 15 - 21, 2002

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 principles.

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 through it.

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 Reserve Assets.

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 maximizes holding-period.

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.