ECON350

Financial Institutions and Markets

Emrehan Aktuğ
Fall-2025
Learning Objectives
• Summarize the features of a bank balance sheet.
• Apply changes to a bank's assets and liabilities on a T-account.
• Identify the ways in which banks can manage their assets and
liabilities to maximize profit.
• List the ways in which banks deal with credit risk.
• Apply gap analysis and duration analysis for interest-rate risk.
• Summarize the types of off-balance-sheet activities.
The Business of Banking
• Central Role: Banks are crucial financial intermediaries, channeling
trillions of dollars from savers to productive borrowers annually.
• How They Profit: Banks make profits by selling liabilities (acquiring
funds) with one set of characteristics and using the proceeds to buy
assets (making loans and buying securities) with a different set. This is
called asset transformation.
• The Challenge: Banks operate in an environment with significant risks
and regulatory constraints.
• This Chapter: Explores how banks manage their operations to
maximize profits while maintaining safety and liquidity.
The Bank Balance Sheet: Overview
• Definition: A list of a bank's assets and liabilities at a specific point in
time.
• Fundamental Identity: Total Assets = Total Liabilities + Bank Capital
• Liabilities: The sources of bank funds (what the bank owes).
• Assets: The uses of bank funds (what the bank owns; these generate
income).
• Bank Capital (Net Worth): The difference between total assets and
total liabilities. The bank's equity.
Bank Balance Sheet: Liabilities (Sources of Funds)
• 1. Checkable Deposits (14% of total liabilities):
• Accounts on which depositors can write checks (e.g., checking
accounts, NOW accounts).
• Payable on demand (highly liquid for depositor).
• Low cost for banks (depositors accept lower/no interest for liquidity).
• 2. Nontransaction Deposits (63% of total liabilities):
• Primary source of bank funds. Cannot write checks. Higher interest
rates than checkable deposits.
• Savings Accounts: Funds can be added/withdrawn at any time.
• Small-Denomination Time Deposits (< $100K): Fixed maturity, less
liquid, higher interest.
• Large-Denomination Time Deposits (CDs > $100K): Negotiable (can be
resold), important for corporate/institutional funds.
• 3. Borrowings (10% of total liabilities):
• Funds from Federal Reserve (discount loans/advances), other banks
(federal funds), parent companies, corporations (repurchase
agreements).
• Have grown significantly in importance.
• 4. Bank Capital (13% of total liabilities):
• Funds raised by selling new equity or retained earnings.
• A cushion against asset value drops.
Bank Balance Sheet: Assets (Uses of Funds)
• 1. Reserves and Cash Items (15% of total assets):
• Reserves: Deposits held at the Fed + Vault Cash (physical currency in
bank vaults).
• Required Reserves: Held due to reserve requirements (regulation from Fed).
• Excess Reserves: Any additional reserves held; highly liquid insurance against
deposit outflows.
• Cash Items in Process of Collection: Checks deposited that haven't
been collected from other banks yet.
• Deposits at Other Banks (Correspondent Banking): Small banks hold
deposits in larger banks for services.
• 2. Securities (20% of total assets):
• Income-earning assets, primarily debt instruments (U.S. banks cannot
hold stocks).
• U.S. Government & Agency Securities: Highly liquid (secondary
reserves), low default risk.
• State & Local Government Securities: Less liquid, higher default risk.
• Other Securities.
• 3. Loans (52% of total assets):
• Primary source of bank profits. Less liquid, higher default risk than
securities.
• Commercial & Industrial Loans: To businesses.
• Real Estate Loans (Mortgages): To households/firms for property.
• Consumer Loans: To individuals.
• Interbank Loans: To other banks.
• 4. Other Assets: Physical capital (bank buildings, computers).
Basic Banking Operations: The T-Account
• T-Account: A simplified balance sheet that shows only the changes in
assets and liabilities.
• Scenario 1: Opening a Checking Account with Cash ($100):
• First National Bank (FNBO)
• Assets: Vault Cash +$100
• Liabilities: Checkable Deposits +$100
• Result: Reserves (vault cash) increase by the same amount as checkable deposits.
• Scenario 2: Jane Brown deposits a check from another bank ($100):
• First National Bank (FNBO)
• Assets: Cash Items in Process of Collection +$100
• Liabilities: Checkable Deposits +$100
• Second National Bank (SNBO)
• Assets: Reserves -$100
• Liabilities: Checkable Deposits -$100
• Result: FNBO gains deposits and reserves; SNBO loses deposits and
reserves. When a bank receives new deposits, it gains an equal amount of
reserves.
Basic Banking Operations: Making Loans
• How Banks Make Profit: By making loans from deposits.
• Scenario: FNBO receives $100 deposit, has 10% required reserves.
• Initial T-account (after deposit):
• Assets: Required Reserves +10, Excess Reserves +90
• Liabilities: Checkable Deposits +$100
• FNBO uses $90 excess reserves to make a loan:
• Assets: Loans +$90 (and Excess Reserves become $0)
• Liabilities: Checkable Deposits +$90 (created when loan is deposited into borrower's account)
• Result: The bank's act of lending created new checkable deposits, which are
part of the money supply!
• Key Idea: Banks "borrow short and lend long."
General Principles of Bank Management
• Bank managers aim to maximize profits by balancing several concerns:
• Liquidity Management: Ensuring enough cash to meet deposit outflows.
• Asset Management: Seeking highest returns on loans/securities while minimizing
risk.
• Liability Management: Acquiring funds at low cost.
• Capital Adequacy Management: Deciding the appropriate amount of bank
capital.
Principle 1: Liquidity Management
• The Challenge: When depositors withdraw cash or write checks
that are deposited elsewhere, a bank loses reserves (deposit
outflows).
• How Banks Acquire Needed Reserves (in order of
preference/cost):
1. Borrow from other banks: In the federal funds market (interest:
federal funds rate). Least costly, least disruptive.
2. Sell securities: Liquid U.S. government securities ("secondary
reserves"). Incurs brokerage costs.
3. Borrow from the Fed: Discount loans at the discount rate. May carry a
"stigma" (suggests bank is in trouble).
4. Reduce loans: Calling in loans or not renewing them. Most costly,
antagonizes customers (lemons problem). Selling loans is also costly.
• Conclusion: Banks hold excess reserves as insurance against
deposit outflows. The higher the costs of reserve shortfalls, the
more excess reserves a bank will hold.
Principle 2: Asset Management
• How banks choose their assets to maximize profits:
• Find good loan opportunities: Seek borrowers who pay high interest rates and
are unlikely to default (screening problem).
• Purchase high-return, low-risk securities: (e.g., U.S. government bonds).
• Diversify asset holdings: Spread risk by holding many different types of assets
(various loans, different securities). Avoid "putting all eggs in one basket."
• Manage liquidity: Hold enough liquid assets (reserves, secondary reserves) to
meet outflows without costly adjustments.
Principle 3: Asset-Liability Management
• Shift from Passive to Active (since 1960s):
• Historically, banks saw deposits as fixed and managed only assets.
• With the rise of large-denomination CDs and the federal funds market, banks
actively began to acquire funds (liabilities) as needed to fund attractive loan
opportunities.
• Impact: Led to increased importance of negotiable CDs and bank
borrowings, and a decrease in the reliance on checkable deposits.
• Asset-Liability Management (ALM): Modern banks manage both sides of
the balance sheet together.
Principle 4: Capital Adequacy Management
• Bank Capital (Net Worth): Assets - Liabilities.
• Why Banks Hold Capital:
• Prevents Bank Failure: Acts as a cushion for losses from asset value declines.
More capital means less chance of insolvency (liabilities > assets).
• Affects Returns to Equity Holders:
• Return on Assets (ROA) = Net Profit After Taxes / Assets (Measures efficiency).
• Return on Equity (ROE) = Net Profit After Taxes / Equity Capital (Measures return to owners).
• Relationship: ROE = ROA * (Assets / Equity Capital)
• Equity Multiplier (EM) = Assets / Equity Capital
• Trade-off: Lower capital (higher EM) leads to higher ROE for a given ROA, but also increases
the risk of insolvency.
• Regulatory Requirements: Minimum capital levels required by authorities (e.g.,
“Basel Accords”, discussed in Chapter 10).
Managing Capital & Credit Crunches
• If ROE is too low (capital surplus):
• Buy back bank stock.
• Increase dividends (reduces retained earnings).
• Keep capital constant, but grow assets (acquire new funds via CDs/borrowings and make
more loans/securities).
• If capital is too low (capital shortfall):
• Issue new equity (common stock).
• Reduce dividends (increase retained earnings).
• Reduce assets (make fewer loans, sell securities, and use proceeds to reduce liabilities) –
this means shrinking the bank.
• Application: How a Capital Crunch Caused a Credit Crunch During the Global
Financial Crisis:
• Losses from subprime mortgages reduced bank capital.
• Raising new capital was difficult due to economic weakness.
• Banks were forced to tighten lending standards and reduce lending (a "credit crunch")
to meet capital requirements.
• This "capital crunch" significantly worsened the 2008-2009 recession.
Managing Credit Risk: Introduction
• Key Advantage of Debt over Equity: Lenders don't need to monitor
continually. They only need to verify firm's activities if it defaults.
• The Problem: Debt contracts still have moral hazard. Borrowers (firms)
might take on excessively risky investment projects once they have the
loan.
• Why? If the risky project succeeds, borrower gets all the upside. If it fails, the
lender takes the loss (borrower's "skin in the game" is limited).
• Example: Steve uses your loan for risky chemical research instead of the ice
cream shop.
Managing Credit Risk: Tools in Practice
• 1. Screening & Monitoring:
• Screening (Adverse Selection): Collecting reliable information on prospective
borrowers to screen out bad risks (e.g., loan applications, credit scores, personal
interviews, business financials).
• Monitoring (Moral Hazard): Verifying borrowers are complying with loan terms
and not engaging in risky activities (e.g., checking financial reports).
• Example: Bank asks you about salary, existing loans for a car loan.
• 2. Specialization in Lending: Banks often specialize in local firms or
specific industries to become experts at collecting information and
monitoring effectively. (Even if it seems to increase diversification risk).
• 3. Long-Term Customer Relationships: Banks gain valuable information
over time from a customer's history (checking/savings accounts, past
loans). Reduces information costs.
Managing Credit Risk: Tools in Practice (Cont.)
• 4. Loan Commitments: A bank's commitment to provide a firm with
loans up to a given amount at an interest rate tied to market rates.
• Promotes long-term relationships and information sharing.
• 5. Collateral and Compensating Balances:
• Collateral: Property pledged to lender if borrower defaults. Reduces losses and
incentive for moral hazard.
• Compensating Balances: Required minimum amount of funds a firm must keep
in a checking account at the lending bank. Acts as collateral and helps bank
monitor firm activity.
• 6. Credit Rationing: Refusing to make loans, or restricting loan size, even
if the borrower is willing to pay the stated interest rate (or higher).
• Prevents Adverse Selection: Riskiest borrowers are most willing to pay high rates.
Turning them down avoids bad risks.
• Prevents Moral Hazard: Larger loans increase borrower's incentive for moral
hazard. Small loans limit this incentive.
Managing Interest-Rate Risk
• Interest-Rate Risk: The riskiness of earnings and returns on bank assets caused
by changes in interest rates.
• Problem: If a bank has more rate-sensitive liabilities than assets, a rise in interest rates
will reduce profits (and vice versa).
• Measurement Tools:
• Gap Analysis: Measures the difference (the "gap") between a bank's rate-sensitive
assets and its rate-sensitive liabilities.
• (Rate-sensitive Assets - Rate-sensitive Liabilities) * Change in
Interest Rate = Change in Profits
• Example: If RSAs = $20M, RSLs = 50M, Gap =-30M. If rates rise 5%, profits fall by $1.5M
• Duration Analysis: Examines the sensitivity of a bank's total asset and liability market
values to interest rate changes, using Macaulay's duration concept (average lifetime of
payments).
• Strategies for Management:
• Alter the balance sheet (shorten duration of assets, lengthen duration of liabilities).
• Use financial instruments like derivatives (forwards, futures, options, swaps) to hedge
risk.
Off-Balance-Sheet Activities
• Definition: Activities that affect bank profits but do not appear on the balance sheet.
Have grown significantly.
• Types of Activities:
• Loan Sales (Secondary Loan Participations): Selling all or part of the cash stream from a specific
loan. Bank earns a fee.
• Generation of Fee Income: Fees for providing specialized services (e.g., foreign exchange trades,
servicing mortgage-backed securities, providing backup lines of credit, standby letters of credit).
• Trading Activities: Banks trade financial instruments (futures, options, swaps, foreign exchange)
for hedging or speculation.
• Increased Risk: These activities expose banks to new risks (e.g., default risk on
guarantees, liquidity risk from backup lines, speculation risk).
• Principal-Agent Problem: Especially severe for trading activities. Traders may take
excessive risks for personal gain (bonuses) knowing the bank bears the losses.
• Global Box: Rogue Traders and the Principal-Agent Problem (Mishkin p. 261): Use examples like
Nick Leeson (Barings), Jerome Kerviel (Société Générale), and the "London Whale" (JP Morgan
Chase) to illustrate the extreme dangers.
• Mitigation: Internal controls, limits on transactions, value-at-risk (VaR), stress testing.
Summary
• The bank balance sheet lists liabilities (sources of funds) and assets (uses
of funds).
• Banks engage in asset transformation, creating money through lending.
• Effective bank management involves balancing liquidity, asset, liability,
and capital adequacy concerns.
• Banks use various tools to manage credit risk (screening, monitoring,
collateral, covenants, rationing) to combat asymmetric information
problems.
• Interest-rate risk is managed using tools like gap and duration analysis.
• Off-balance-sheet activities offer new profit sources but introduce new
risks, especially from principal-agent problems.