Introduction to Finance

LEARNING ACTIVITY
1. Go to the St. Louis Federal Reserve Bank’s website for fi nancial and economic data 
(referred to as FRED), http://www.stlouisfed.org, and fi nd current information on 
the prime rate charged by commercial banks.
2. Go to the Chase Corporation website, http://www.chase.com. Find information on 
types of personal loans and their costs.
3.8
Bank Management
Banks are managed to make profi ts and increase the wealth of their owners. However, bank 
management must also consider the interests of depositors and bank regulators. Profi tabil-
ity often can be increased when bank managers take on more risk at the expense of bank 
safety. The lower the level of bank safety is, the greater the likelihood of bank failure will be. 
Bank managers must trade off higher profi tability objectives against the desire of depositors 
to maintain the safety of their deposits. Bank regulators try to ensure that bank managers are 
prudent in their trade-off decisions between profi tability and risk or safety.
Banks can fail either because of inadequate liquidity or by becoming insolvent. 
Bank 
liquidity
refl ects the ability to meet depositor withdrawals and to pay off other liabilities when 
they come due. The inability to meet withdrawal and debt repayments results in bank failure. 
Bank solvency
refl ects the ability to keep the value of a bank’s assets greater than its liabil-
ities. When the value of a bank’s liabilities exceeds its assets, the bank is insolvent and, thus, 
has “failed.” However, from a technical standpoint failure does not take place until depositors 
or creditors are not paid and consequently take legal action. 
Figure 3.6
illustrates the trade-off
involving profi tability and bank safety, or risk. Bank managers manage their bank’s riskiness 
in terms of bank liquidity and bank solvency. We will fi rst discuss bank liquidity management 
and then cover the issue of bank solvency in terms of capital adequacy management.
Liquidity Management
Liquidity management is the management of a bank’s 
liquidity risk
, which is the likelihood 
that the bank will be unable to meet its depositor withdrawal demands and/or other liabilities 
when they are due. Figure 3.6 shows that lower liquidity risk is associated with higher bank 
safety and generally lower bank profi ts. The opposite is the case when bank managers choose 
to take on greater liquidity risk to improve profi ts. In deciding on how much liquidity risk 
is appropriate, bank managers make asset management and liability management decisions.