CHAPTER 7: COMMERCIAL
BANKS
THE BANK BALANCE SHEET
133
THE BANK BALANCE SHEET
• Total assets = Total liabilities + capital
• A bank's balance sheet is also a list of its sources of bank funds
(liabilities) and uses to which the funds are put (assets).
• Banks obtain funds by borrowing and by issuing other liabilities
such as deposits. They then use these funds to acquire assets such as
securities and loans.
• Banks make profits by charging an interest rate on their asset hold-
ings of securities and loans that is higher than the interest and other
expenses on their liabilities
134
THE BANK BALANCE SHEET
Checkable deposits
• Checkable deposits are bank accounts that allow the owner of the
account to write checks to third parties.
• Checkable deposits include all accounts on which checks can be
drawn:
• non-interest-bearing checking accounts (demand deposits),
• interest-bearing NOW (negotiable order of withdrawal) accounts,
and
• money market deposit accounts (MMDAs).
135
THE BANK BALANCE SHEET
• Checkable deposits and money market deposit accounts are
payable on demand;
• If a depositor shows up at the bank and requests payment by making
a withdrawal, the bank must pay the depositor immediately.
• Similarly, if a person who receives a check written on an account from
a bank, presents that check at the bank, it must pay the funds out
immediately (or credit them to that person's account) .
136
THE BANK BALANCE SHEET
• In recent years , interest paid on deposits (checkable and non
transaction) has accounted for around 25% of total bank operating
expenses,
• The costs involved in servicing accounts (employee salaries, building
rent, and so on) have been approximately 50% of operating
expenses.
137
THE BANK BALANCE SHEET
Non transaction deposits
• Non transaction deposits are the primary source of bank funds
• Owners cannot write checks on non transaction deposits , but the
interest rates paid on these deposits are usually higher than those on
checkable deposits.
• There are two basic types of non transaction deposits: savings
accounts and time deposits (also called certificates of deposit, or
CDs).
138
THE BANK BALANCE SHEET
Borrowings
• Borrowings: Banks also obtain funds by borrowing from the Federal
Reserve System, the Federal Home Loan banks, other banks, and
corporations.
• Borrowings from the Fed are called discount loans (also known as
advances). Banks also borrow reserves overnight in the federal (fed)
funds market from other US banks and financial institutions.
139
THE BANK BALANCE SHEET
Borrowings
• Banks borrow funds overnight to have enough deposits at the Federal
Reserve to meet the amount required by the Fed.
• Other sources of borrowed funds are loans made to banks by their
parent companies (bank holding companies), loan arrangements with
corporations (such as repurchase agreements)…
140
THE BANK BALANCE SHEET
Bank Capital
• Bank Capital, the bank's net worth, which equals the difference
between total assets and liabilities.
• Bank capital is a cushion against a drop in the value of its assets,
which could force the bank into insolvency.
141
THE BANK BALANCE SHEET
Reserves
• Reserves are these deposits plus currency that is physically held by
banks (called vault cash because it is stored in bank vaults overnight)
• Although reserves earn a low interest rate, banks hold them for two
reasons. First, some reserves, called required reserves, and some are
called excess reserves.
142
THE BANK BALANCE SHEET
Cash items
• Cash Items in Process of Collection: A check written on an account
at another bank is deposited in your bank
• Deposits at Other Banks: Many small banks hold deposits in larger
banks in exchange for a variety of services, including check collection,
foreign exchange transactions, and help with securities purchases.
• Collectively, reserves, cash items in process of collection, and deposits
at other banks are referred to as cash items.
143
THE BANK BALANCE SHEET
Securities- Loans- Other Assets
• Securities: can be classified into three categories: U.S. government
and agency securities, state and local government securities, and
other securities. Because of their high liquidity, short-term U.S.
government securities are called secondary reserves.
• Loans: Banks make their profits primarily by issuing loans
• Other Assets: The physical capital (bank buildings, computers, and
other equipment) owned by the banks is included in this category.
144
BASIC BANKING—CASH DEPOSIT
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100
Cash deposits deposits
Opening of a checking account leads to an increase in the bank’s
reserves equal to the increase in checkable deposits
145
BASIC BANKING—CHECK DEPOSIT
First National Bank
Assets Liabilities
Cash items in +$100 Checkable +$100
process of deposits
collection
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100
deposits deposits
146
BASIC BANKING—MAKING A PROFIT
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Required +$100 Checkable +$100 Required +$100 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves
• Asset transformation-selling liabilities with one set of characteristics and
using the proceeds to buy assets with a different set of characteristics
• The bank borrows short and lends long
147
BANK MANAGEMENT
• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
148
LIQUIDITY MANAGEMENT: AMPLE EXCESS RESERVES
Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M
• If a bank has ample excess reserves, a deposit outflow does not
necessitate changes in other parts of its balance sheet
149
LIQUIDITY MANAGEMENT: SHORTFALL IN RESERVES
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M
• Reserves are a legal requirement and the shortfall must be
eliminated
• Excess reserves are insurance against the costs associated with
deposit outflows
150
LIQUIDITY MANAGEMENT: BORROWING
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
• Cost incurred is the interest rate paid on the borrowed funds
151
LIQUIDITY MANAGEMENT: SECURITIES SALE
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M
• The cost of selling securities is the brokerage and other transaction
costs
152
LIQUIDITY MANAGEMENT: BORROWING FROM FEDERAL RESERVE
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M
• Borrowing from the Fed also incurs interest payments based on the
discount rate
153
LIQUIDITY MANAGEMENT: REDUCE LOANS
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M
• Reduction of loans is the most costly way of acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a substantial discount
154
ASSET MANAGEMENT: THREE GOALS
• Seek the highest possible returns on loans and securities
• Reduce risk
• Have adequate liquidity
155
ASSET MANAGEMENT: FOUR TOOLS
• Find borrowers who will pay high interest rates and have low
possibility of defaulting
• Purchase securities with high returns and low risk
• Lower risk by diversifying
• Balance need for liquidity against increased returns from less liquid
assets
156
LIABILITY MANAGEMENT
• Recent phenomenon due to rise of money center banks
• Expansion of overnight loan markets and new financial instruments
(such as negotiable CDs)
• Checkable deposits have decreased in importance as source of bank
funds
157
CAPITAL ADEQUACY MANAGEMENT
• Bank capital helps prevent bank failure
• The amount of capital affects return for the owners (equity holders)
of the bank
• Regulatory requirement
158
CAPITAL ADEQUACY MANAGEMENT: PREVENTING BANK FAILURE WHEN ASSETS DECLINE
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
159
CAPITAL ADEQUACY MANAGEMENT: RETURNS TO EQUITY HOLDERS
160
CAPITAL ADEQUACY MANAGEMENT: SAFETY
• Benefits the owners of a bank by making their investment safe
• Costly to owners of a bank because the higher the bank capital, the
lower the return on equity
• Choice depends on the state of the economy and levels of confidence
161
CREDIT RISK: OVERCOMING ADVERSE SELECTION AND MORAL
HAZARD
• Screening and information collection
• Specialization in lending
• Monitoring and enforcement of restrictive covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
162
INTEREST-RATE RISK
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
• I Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
• If a bank has more rate-sensitive liabilities than assets, a rise in interest rates
will reduce bank profits and a decline in interest rates will raise bank profits
163