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 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii
About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xx

Chapter 1
Banking and the Financial Services Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Global Financial Crisis of 2007–2009 2
How Do Banks Differ? 7
Organizational Structure 15
Financial Services Business Models 18
Too Big to Fail Banks 23
Different Channels for Delivering Banking Services 25
Summary 26
Questions 27
Activities 28
References 28

Chapter 2
Government Policies and Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Historical Bank Regulation 32
Goals and Functions of Depository Institution Regulation 32
Ensure Safety and Soundness and Provide an Efficient and Competitive System 34
New Charters 35
Shortcomings of Restrictive Bank Regulation 44
Maintaining Monetary Stability and the Integrity of the Payments System 44
Efficient and Competitive Financial System 50
Too Big To Fail 60
Summary 63
Questions 64
Activities 65
References 65

Chapter 3
Analyzing Bank Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Commercial Bank Financial Statements 69
The Relationship between the Balance Sheet and Income Statement 90
The Return on Equity Model 91
Managing Risk and Returns 100
Financial Statement Manipulation 131
Summary 134
Questions 134
Problems 136
References 137
Appendix 139

vi i
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viii Contents

Chapter 4
Managing Noninterest Income and Noninterest Expense . . . . . . . . . . . . . . . . . . . . . . . 159
Noninterest Income 164
Noninterest Expense 169
Which Lines of Business and Customers Are Profitable? 174
Summary 184
Questions 185
Activity 186
References 186

Chapter 5
The Performance of Nontraditional Banking Companies . . . . . . . . . . . . . . . . . . . . . . 189
The Disappearance of Large Investment Banks 191
Goldman Sachs Group, Inc., and Goldman Sachs Bank USA 193
The Financial Performance of Mutual of Omaha Bank 202
The Financial Performance of BMW Financial Services and BMW Bank of North America 205
Summary 209
Questions 210
Activities 210
References 211

Chapter 6
Pricing Fixed-Income Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
The Mathematics of Interest Rates 214
Simple versus Compound Interest 217
The Relationship between Interest Rates and Option-Free Bond Prices 219
Duration and Price Volatility 224
Recent Innovations in the Valuation of Fixed-Income Securities and Total Return Analysis 229
Money Market Yields 233
Summary 236
Questions 237
Activities 239
References 240

Chapter 7
Managing Interest Rate Risk: GAP and Earnings Sensitivity . . . . . . . . . . . . . . . . . . . 241
Measuring Interest Rate Risk with GAP 245
Earnings Sensitivity Analysis 263
Income Statement GAP 272
Managing the GAP and Earnings Sensitivity Risk 274
Summary 275
Questions 276
Activities 279
References 281

Chapter 8
Managing Interest Rate Risk: Economic Value of Equity . . . . . . . . . . . . . . . . . . . . . . . 283
Measuring Interest Rate Risk with Duration Gap 285
Economic Value of Equity Sensitivity Analysis 295
Earnings Sensitivity Analysis versus EVE Sensitivity Analysis: Which Model Is Better? 298

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 Contents ix

A Critique of Strategies for Managing Earnings and Economic Value of Equity Sensitivity 301
Yield Curve Strategies 303
Summary 305
Questions 305
Activity 307
References 307

Chapter 9
Using Derivatives to Manage Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Characteristics of Financial Futures 310
Speculation versus Hedging 319
Microhedging Applications 327
Macrohedging Applications 330
Using Forward Rate Agreements to Manage Rate Risk 333
Basic Interest Rate Swaps as a Risk Management Tool 335
Interest Rate Caps and Floors 342
Summary 357
Questions 357
Activities 361
References 364

Chapter 10
Funding the Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
The Relationship between Liquidity Requirements, Cash, and Funding Sources 366
Characteristics of Retail-Type Deposits 370
Characteristics of Large Wholesale Liabilities 379
Electronic Money 390
Check 21 392
Measuring the Cost of Funds 395
The Average Historical Cost of Funds 396
Funding Sources and Banking Risks 403
Summary 405
Questions 406
Problems 408
References 409

Chapter 11
Managing Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
Meeting Liquidity Needs 414
Reserve Balances at the Federal Reserve Bank 418
Required Reserves and Monetary Policy 418
Meeting Legal Reserve Requirements 421
Liquidity Planning 427
Traditional Aggregate Measures of Liquidity Risk 433
Basel III and the Liquidity Coverage Ratio 436
Longer-Term Liquidity Planning 437
Contingency Funding Plans 442
Summary 445
Questions 445
Activity 447
References 447

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
x Contents

Chapter 12
The Effective Use of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
Why Worry about Bank Capital? 450
Risk-Based Capital Standards 451
What Constitutes Bank Capital? 458
Tangible Common Equity 461
What Is the Function of Bank Capital? 463
How Much Capital Is Adequate? 466
The Effect of Capital Requirements on Bank Operating Policies 467
Characteristics of External Capital Sources 471
Contingent Convertible Capital 472
Capital Planning 474
Depository Institution Capital Standards 478
Changes to Capital Standards Under Basel III 478
Summary 481
Questions 481
Problems 483
References 484

Chapter 13
Overview of Credit Policy and Loan Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . 485
Recent Trends in Loan Growth and Quality 486
Measuring Aggregate Asset Quality 495
The Credit Process 497
Characteristics of Different Types of Loans 507
Summary 522
Questions 522
Problems 523
Activity 524
References 524

Chapter 14
Evaluating Commercial Loan Requests and Managing Credit Risk . . . . . . . . . . . . . . 527
Fundamental Credit Issues 529
Evaluating Credit Requests: A Four-Part Process 534
Credit Analysis Application: Wade’s Office Furniture 555
Managing Risk with Loan Sales and Credit Derivatives 570
Summary 574
Questions 574
Problems 577
References 580
Appendix I 582
Appendix II 584
Appendix III 585

Chapter 15
Evaluating Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
Types of Consumer Loans 589
Consumer Credit Regulations 599
Credit Analysis 607

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 Contents x i

Recent Risk and Return Characteristics of Consumer Loans 617

Summary 620
Questions 620
Problems 622
Activities 622
References 623

Chapter 16
Managing the Investment Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625
Dealer Operations and the Securities Trading Account 627
Dodd–Frank Act Provisions Affecting Bank Investments 628
Objectives of the Investment Portfolio 629
Composition of the Investment Portfolio 633
Characteristics of Taxable Securities 634
Prepayment Risk on Mortgage-Backed Securities 645
Characteristics of Municipal Securities 653
Establishing Investment Policy Guidelines 658
What Are Suitable Investment Securities? 659
Active Investment Strategies 660
The Impact of Interest Rates on the Value of Securities with Embedded Options 667
Comparative Yields on Taxable versus Tax-Exempt Securities 677
The Impact of the Tax Reform Act of 1986 681
Strategies Underlying Security Swaps 683
Summary 686
Questions 687
Problems 689
Activity 690
References 691

Chapter 17
Global Banking Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693
U.S. Depository Institutions in the World Market 693
Impact of the Credit Crisis of 2007–2008 697
The European Community 703
Universal Banking Model 704
Organizational Structure of U.S. Banks with Foreign Operations 706
International Financial Markets 708
International Lending 711
Foreign Exchange Activities 717
Summary 721
Questions 722
References 723

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 753

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 Preface
The world of banking has changed dramatically since 2007 when many large financial
institutions around the world failed and were bailed out by their central governments.
The United States and global economies subsequently fell into recession. Millions of
Americans lost their jobs, and household net worth plummeted with the decline in hous-
ing and the value of investments. The ongoing recovery continues to be slow and painful
for many. Not surprisingly, the reputations of many banks and the banking industry in
general have suffered. Yet, if done correctly, banking is a critical driver of economic
activity and a noble profession. It involves the processing of payments, accepting depos-
its and making loans, safekeeping documents and valuable items, providing guarantees
and performance bonds, offering cash management, brokerage and insurance services,
and providing securities underwriting and market-making services.
So, what caused a breakdown in the financial services industry leading to the recent
financial crisis? In 2011, the National Commission on the Causes of the Financial and
Economic Crisis in the United States published a report that said both senior manage-
ment at large financial institutions and key government officials ignored warning signals
and inadequately managed risks; and that the crisis was avoidable.1 It attributed the crisis
to: (1) risky lending via subprime mortgages; (2) trading activities at large institutions;
(3) unregulated derivatives markets; and (4) problems with lending via repurchase agree-
ments, among other factors. In response, the U.S. Congress passed the Dodd–Frank Wall
Street Reform and Consumer Protection Act in June 2010 (commonly labeled the Dodd–
Frank Act), which has produced and continues to produce numerous changes in the reg-
ulation of financial firms. The global crisis has similarly brought about changes in regu-
lations at financial firms in other industrialized countries.
One of the most unusual results of the crisis and subsequent pressures from the new
regulatory environment is that the largest institutions appear to be benefiting financially
more than smaller institutions. For example, from 2000 to 2013, the five largest banks in
the United States increased their share of total U.S. banking assets from 27.5 percent to
46.6 percent.2 In addition, regulators have been slow to charter new banks, and many
smaller bank managers and owners routinely protest that the impact of new consumer
regulations is to reduce lending and raise their deadweight costs, thereby making it
more difficult to compete with other organizations.
How did we get where we are today? Commercial banks in the U.S. started as firms that
focused on payment processing, the storage of financial documents and valuable items, and
eventually moved into lending to individuals and businesses. They were largely unregulated
until the Great Depression when more than 600 banks failed from 1921–1929. From 1930
to 1933, more than 9,000 banks suspended operations. With lack of confidence in the
financial system, customers attempted to convert bank deposits to cash, thereby creating
“runs on banks.” The Banking Act of 1933, now commonly labeled the Glass–Steagall
Act, established the Federal Deposit Insurance Corporation (FDIC) responsible for insur-
ing customer deposits at banks. It also separated commerce from banking activities. As
such, commercial banks focused on accepting deposits, making loans and holding the
1
The Financial Crisis Inquiry Report, Final Report of the National Commission on the Causes of the Financial
and Economic Crisis in the United States, Public Affairs, January 2011.
2
Pierce, Hester and Robert Greene, “The Decline of U.S. Small Banks (2000–2013),” www.mercatus.org,
February 24, 2014.
xiii
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xiv Preface

loans in portfolio. Investment banks focused on making markets, underwriting securities,

and facilitating mergers and acquisitions. As large firms grew in size, they moved into
other types of financial businesses. The Bank Holding Company Act formally identified
businesses in which commercial bank holding companies might engage after receiving reg-
ulatory approval. Over time, Congress authorized commercial banks to move into invest-
ment banking, insurance underwriting, and other once-prohibited services, deeming the
risks acceptable. Many large investment banks similarly made loans and held large
amounts of the loans and securities in portfolio funded largely by short-term repurchase
agreements. Then, the global financial crisis hit.
In 2008, the United States lost more than 2.5 million jobs. Large private firms once
thought to be the leaders of growth are now principally owned by federal governments.
Quasi-private agencies, such as the Federal National Mortgage Association (FNMA)
and Federal Home Loan Mortgage Corporation (FHLMC), are effectively owned by the
U.S. government. Lehman Brothers failed. Other large financial institutions effectively
failed and were collapsed into stronger, surviving institutions. Thus, Bank of America
acquired Countrywide and Merrill Lynch. JPMorgan Chase acquired Bear Stearns and
Washington Mutual. Wells Fargo acquired Wachovia. Goldman Sachs and Morgan Stan-
ley, once premier investment banks, converted to financial (bank) holding companies to
get access to borrowings from the Federal Reserve. Other noncommercial banks, such as
American Express, The Hartford, GE Capital, and MetLife also became financial holding
companies so that they could borrow from the Federal Reserve. In 2014, Congress still
had not decided what to do with Fannie Mae and Freddie Mac, who then dominated
the mortgage market. From 2008 to 2010, governments flooded the markets with liquid-
ity, recognizing that many credit markets were no longer functioning effectively. Asset
securitizations dried up as the originate-to-distribute model fell out of favor. Financial
institutions, businesses, and individuals started and continue to deleverage by which
they pay down debt. While economic growth eventually turned positive, the pace has
been slow relative to historical norms.
Given the extreme problems of financial institutions and general atmosphere of fear,
the U.S. Congress authorized a Troubled Asset Relief Program (TARP)—Capital
Purchase Program through which the federal government bought preferred stock in
qualifying financial institutions. While this helped stabilize large financial institutions,
the global economy still suffered. By 2009, the Obama administration and Congress
had approved a massive stimulus plan involving tax cuts and increased government
spending in an effort to jump-start consumer and business spending. Importantly, the
policies were designed to raise consumer and business spending and confidence, which
had eroded with recent events. Governments in China, the United Kingdom and
throughout the industrialized world implemented similar types of stimulus plans.
Today, the banking industry across the world has permanently changed. Investment
banks, as traditionally structured, no longer exist as independent organizations. The
Dodd–Frank Act imposes a wide range of new regulations that continue to be developed
and implemented. Given excessive financial leverage, governments in the industrialized
world approved Basel III, which served to increase capital requirements at banks. As
such, the nature of bank risk taking has changed. Lending decisions have been refocused
on a borrower’s ability and willingness to repay, because the model of originating and
then selling loans broke down. Finally, the financial industry is again consolidating.
This book examines the impacts of the changing competitive environment on com-
mercial banks, banking services, and to a lesser degree the entire financial services indus-
try. Upon completing the book, the reader will better understand how banks make a
profit and the risks associated with managing a bank’s balance sheet. It will address the
mechanics of and issues associated with making loans, buying and selling securities,

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 Preface x v

competing for deposits, accessing purchased liabilities, and building the capital base. It
also addresses related activities involving securitization and the use of financial deriva-
tives. In response to issues raised during the financial crisis, it demonstrates the conse-
quences of making bad loans, operating with excessive leverage, and inadequate liquidity.
The analysis provides a framework for developing effective strategies to ensure the
proper balance between management’s profit targets and allowable risk taking.

Audience
Bank Management is designed for use in upper division undergraduate or master’s level
banking and financial institutions courses at universities, as well as training programs for
professional bankers. As prerequisites, students should be familiar with elementary
accounting, basic interest rate and bond pricing concepts, and basic macroeconomics.
The book is well suited for broad-based instructional purposes in bank training pro-
grams, because it emphasis how decisions are made and the consequences of different
types of decisions. For someone new to banking, the book describes the range of banking
activities and demonstrates how bank managers make financial decisions. For practi-
tioners, it presents traditional decision models and explains how decisions in one area
affect performance and opportunities in other areas. This book therefore provides a com-
prehensive view of balance sheet management with an emphasis on the trade-offs
between profitability and risk.

About Bank Management

The book focuses on decision making and offers a unique approach to understanding
commercial bank management. Key chapters address the specific aspects of an issue or
problem, explain how a financial model or decision framework applies, and then demon-
strate the application of the model or framework using sample data analysis. The reader
not only observes how certain factors influence credit, investment, funding, and pricing
decisions, but also develops an appreciation of the trade-offs between return and risk.
Several Microsoft Excel templates, which include various models and applications using
sample data, are available to users. End-of-chapter cases, questions, and problems pro-
vide an opportunity to test the reader’s understanding of important issues and data
analysis.
After reading Bank Management, the reader should have a solid foundation in the key
issues confronting managers today, a familiarization with the basic financial models that
are used to formulate decisions, and an understanding of the strengths and weaknesses
of data analysis. The text and numerous applications help the reader to recognize the
trade-offs involved in making financial decisions and to develop the logical thought pro-
cesses needed to reach reasonable conclusions.

New Features of the Eighth Edition

The eighth edition of the book builds on the topics and features of earlier editions, with
several important changes:
• A complete regulatory update has been applied throughout the book. In particular,
the book examines the many programs evolving from the financial crisis that focus
on providing liquidity to the banking system as well as key provisions of the Dodd–
Frank Act and Basel III. Included are discussions of the Troubled Asset Relief Pro-
gram (TARP–CPP), the Temporary Liquidity Guarantee Program (TLGP), and the

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xvi Preface

Term Securities Lending Facility (TSLF). It discusses recent decisions of the Con-
sumer Financial Protection Bureau (CFPB) and their implications, as well as other
provisions of the Dodd–Frank Act.
• It examines the role that periodic stress testing under the reglators’ Comprehensive
Capital Analysis and Review (CCAR) plays in influencing bank capital decisions.
• A complete discussion of the changing landscape of the financial services industry—
including the evolution of investment banks, mortgage lenders and life insurance
companies.
• An analysis of the subprime mortgage crisis, its impact on financial institutions and
the economy, and regulatory responses.
• A discussion of the originate-to-distribute model and reasons it is out of favor.
• A description of credit default swaps, how firms use them to hedge and speculate, as
well as a discussion of the role they played in increasing financial leverage and risk
to financial institutions and the financial system.
• A summary of Citigroup’s holding company structure and financial data.
• A detail analysis and comparison of various tradition and non tradition banking
business models using data from Goldman Sachs Group, Goldman Sachs Bank,
Mutual of Omaha Bank and BWW Bank of North America.
• An updated and comprehensive evaluation of commercial bank performance and the
impact this has on the analyst’s job in evaluating performance; a direct comparison
of PNC Bank’s financial performance in 2013 versus peer institutions as well as
important contrasts with the performance of community banks.
• An evaluation and comparison of PNC Bank’s financial performance before, during
and after the financial crisis of 2008–2009.
• An analysis of the Dodd–Frank Act impact on not allowing banks to rely exclusively
on credit ratings when making security investment decisions.
• New data and analysis on international banking and the role and size of U.S. bank-
ing institutions abroad, as well as the ownership and composition of foreign banking
institutions in the United States.
• This book remains the only text that focuses on cash-flow analysis as part of the
lending decision. It introduces a comprehensive procedure for generating cash-based
income statements, explains how to interpret the results, and provides an approach
to forecasting a potential borrower’s future performance.

Organization of the Book

While the unifying theme of the book is risk management, the material is divided into
six parts. As a lead-in to each chapter, the text will describe a current issue or provide an
example of a key topic discussed in the chapter. This introduction reinforces the risk
focus by emphasizing that although managers make both good and bad decisions, the
consistent application of finance theory and models should lead to a better understand-
ing of the trade-off between risk and return.
Part I, Overview of the Banking Industry and Regulation, provides background informa-
tion related to bank management, the regulatory environment, and current banking trends.
Initially, it provides a critique of the multitude of factors influencing the financial crisis of
2008–2010. It examines the organizational structure of small banks and large bank holding
companies and describes different models of banking including a discussion of industrial
loan companies. It describes the current regulatory environment including key provisions
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 Preface x v i i

of the Dodd–Frank Act and Basel III and explains the impact of government policies to
provide emergency liquidity and stress test financial performance and viability.
Part II, Evaluating Bank Performance, examines the basic risk and return features of banks
and how analysts evaluate performance. Chapter 3 introduces bank financial statements
and presents the traditional DuPont model for evaluating bank performance using
financial ratios from the Uniform Bank Performance Report (UBPR) to analyze the
strengths and weaknesses of bank performance over time and versus peer institutions. It
provides the foundation and building blocks for understanding how banks make a profit
and the trade-offs involved in balancing credit risk, liquidity risk, market risk, operational
risk, reputational risk, legal risk, and solvency risk. Chapter 4 documents recent strategies
and trends in controlling noninterest expense relative to noninterest income to help
meet efficiency objectives. Chapter 5 documents differences in nontraditional banking
organizations by focusing on the performance of Goldman Sachs, Mutual of Omaha
Bank, and BMW Bank, organizations that were once purely an investment bank, insur-
ance company, and automobile manufacturer/finance company, respectively.
Part III, Managing Interest Rate Risk, demonstrates how banks measure and manage
interest rate risk. Chapter 6 provides background information on the pricing of securi-
ties, total return analysis to investors, and the determinants of interest rates. Chapter 7
introduces GAP analysis and the use of earnings sensitivity analysis to assess the poten-
tial impact of interest rate and balance sheet changes on net interest income. Chapter 8
describes duration gap analysis and the use of sensitivity analysis to assess the potential
impact of interest rate and balance sheet changes on the economic value of stockholders’
equity. The discussion emphasizes the impact of embedded options and the necessity
behind incorporating sensitivity analysis to assess the impact of such options on profits
and risk. Attention is paid to the possible impact of rising rates on bank earnings and
risk. Chapter 9 describes the basic features of financial futures, forward contracts, interest
rate swaps, and interest rate caps and floors and explains how banks use them to both
hedge and speculate. Emphasis is directed toward understanding the models, data output,
and strategies to improve performance.
Part IV, Managing the Cost of Funds, Capital, and Liquidity, describes the features of
bank liabilities, regulatory capital requirements, and overall liquidity analysis. It presents
a procedure for estimating the marginal cost of funds that is used in making investment
decisions and pricing assets. It also explains how banks meet legal reserve requirements
and manage cash assets, and it develops a model for estimating liquidity needs and plan-
ning for temporary cash deficiencies as well as longer-term liquidity needs. A key section
describes the importance and nature of contingency funding plans at banks. Chapter 12
documents risk-based capital requirements and outlines strategies for obtaining new
external capital. It introduces features of Basel III that will alter the largest institutions’
capital requirements starting in 2015 and smaller institutions’ capital requirements at
later dates. Finally, it describes federal government stress-testing efforts to evaluate the
adequacy of bank capital.
Part V, Managing Credit Risk, addresses how banks manage credit risk. It initially
describes basic credit analysis principles and the characteristics of different types of
loans. Subsequent chapters present a procedure for estimating a business borrower’s
cash flow from operations and the basic credit scoring models applied to individual
borrowers. Considerable emphasis is placed on interpreting financial statements and
generating cash flow estimates to determine repayment prospects. Given the recessionary
environment of 2008 and beyond, some of the discussion focuses on the deterioration of
asset quality at banks and the potential impacts on loan workouts. As part of credit risk
management practices, the discussion introduces credit default swaps and explains how
they may be used to speculate and hedge credit risk.

Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
x v ii i Preface

Part VI, Managing the Investment Portfolio and Special Topics, describes the role of
fixed-income securities in helping a bank meet profit and risk objectives. In response to
Dodd–Frank Act provisions, it discusses how banks should now use information provided
by credit rating agencies in making investment decisions. It identifies the basic objectives
of a bank’s investment portfolio and the nature of investment policy guidelines, and
explains the basic features of taxable and tax-exempt securities that banks buy. It then
introduces various strategies related to choosing security maturities, the composition
between taxable and tax-exempt securities, and purchases or sales timed to take advantage
of the business cycle. It explains the impact of embedded options on security pricing and
the risk-return trade-off to investors of callable bonds and mortgage-backed securities
with significant prepayment risk. The final chapter describes recent trends in global
banking activities and the management of foreign exchange risk.
Each chapter of Bank Management concludes with a series of discussion questions
and problems that require the student to apply the decision models introduced in the
chapter. Excel templates can be used to generate and address additional problems as
well as provide a useful tool for future analysis.

Web Site
The product-support Web site, located at www.cengagebrain.com, contains the PowerPoint
slide presentation, Instructor’s Manual, and Spreadsheet Templates.

Instructor’s Manual and Test Bank

A comprehensive Instructor’s Manual and Test Bank accompany Bank Management and
can be found on this title’s companion website at www.cengagebrain.com. These supple-
ments provide teaching objectives and outlines for each chapter and offer detailed
answers to end-of-chapter questions and problems. Finally, multiple choice questions
are provided, with answers.

Lecture Presentation Software

Microsoft PowerPoint™ presentations are also available on the companion Web site to
those professors who wish to incorporate multimedia in the classroom. This multimedia
presentation allows the student to explore the almost unlimited number of different
financial situations that banks face on a daily basis. Furthermore, it provides the instruc-
tor a method by which he or she can integrate a financial analysis spreadsheet template
directly into the class presentation. Many tables and diagrams are featured in the lecture
software package.

Spreadsheet Template
Microsoft Excel templates are available for those who wish to use microcomputers to
perform and extend the data analysis presented in the book. The templates provide a
generic decision model for applications related to analyzing bank performance and key
financial ratios, and cash flow from operations for nonfinancial firms. The templates also
provide a full range of decision models with data for key problems and cases in the text.
Students can use the templates to analyze historical balance sheet and income statement
data and conduct “what if” analysis. This allows the user to quickly examine a range of
outcomes rather than just simple, static solutions. The templates cover topics including
bank performance analysis, duration analysis, risk-based capital requirements and plan-
ning, credit analysis, and customer profitability analysis.
Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
 Preface x ix

Accessing CengageBrain
1. Use your browser to go to www.CengageBrain.com.
2. The first time you go to the site, you will need to register. It’s free. Click on “Sign Up” in
the top right corner of the page and fill out the registration information. (After you have
signed in once, whenever you return to CengageBrain, you will enter the user name and
password you have chosen, and you will be taken directly to the companion site for your
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3. Once you have registered and logged in for the first time, go to the “Search for Books or
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Acknowledgments
Throughout the writing of the eighth edition, we have relied on the assistance and exper-
tise of many friends in the banking industry and academic community. This revision has
benefited from ongoing discussions with the following individuals and former students.
We especially thank David Chappell, Don Childears, William Chittenden, Ken Cyree,
David Davis, Dona de St. Aubin, Charles Funk, Jeff Gerrish, Scott Hein, Jeff Judy, Nick
Ketcha, Randy King, Ed Krei, Don Musso, Karl Nelson, Scott Polakoff, Merrill Reynolds,
Mike Stevens, and Randy Woodward.
Finally, we want to thank our families—Susan, Michala, and Andy; and Becky, Cassy,
and Erin, Jeff and Weston—for their encouragement, support, and insights into seeing
this project through to completion.

Timothy W. Koch, Ph.D. S. Scott MacDonald, Ph.D.

Moore School of Business Southwestern Graduate School
University of South Carolina & of Banking
Graduate School of Banking at Cox School of Business
Colorado Southern Methodist University
Columbia, SC 29208 Dallas, TX 75275

Copyright 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
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