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Chapter 9 Banking and Management of Financial Institutions

Chapter 9 Banking and Management of Financial Institutions

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Published by coldpassion
Econ 248, By Dr.Alwosabi
Econ 248, By Dr.Alwosabi

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Published by: coldpassion on Dec 07, 2009
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02/26/2013

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Chapter 9Banking and Management of Financial Institutions
Because banking system plays a major role in channeling funds from thesavers/lenders to investors/borrowers, it is important to study how thebanking system runs its business to maximize its profit, how and whybanks make loans, how they acquire funds and manage their assets andliabilities.
THE BANK BALANCE SHEET
To understand how banking works we start by looking at the bank balancesheet.
The bank
balance sheet
is a list of the bank assets (what bank owns) andliabilities (what it owes) where,Total assets = total liabilities + bank’s equity capital (net worth)
Banks make profits by receiving interest rates on their asset holdings of securities and loans that is higher than the expenses of their liabilities.
Liabilities
Liabilities are the sources of bank’s funds. Banks obtain funds by borrowingand by issuing (selling) other liabilities such as deposits. Liabilities include
o
 
Checkable Deposits
 They are bank accounts that allow the owner of the account to writechecks to third parties. Checkable deposits include (1) non-interestbearing checking account (demand deposits), (2) interest-bearingaccounts (NOW accounts: negotiable order of withdrawal), and (3)money market deposit accounts (MMDAs).
 
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MMDAs are not subject to reserve requirements as checkabledeposits are, and are not included in the M1 definition of money.Checkable deposits and money market deposit accounts are payableon demand.
o
 
Non-transaction deposits
 They are the main source of bank funds. Owners cannot writechecks on non-transaction deposits, but the interest rates paid onthese deposits are usually higher than those on checkable deposits.There are two basic types of non-transaction deposits: savingaccounts and time deposits (also called CDs).
 
Saving accounts
, which funds can be added to or withdrawnfrom at any time.
 
Time deposits
have a fixed maturity length and charge highpenalties for early withdrawal. They are less liquid than savingaccounts but earn higher interest rate.
o
 
Borrowings
 Banks also obtain funds by borrowing from the central bank, other commercial banks, and corporations.
o
 
Bank Capital
 Bank capital or net worth is the difference between total assets andtotal liabilities. Bank capital is raised by selling new equity (stock) or retained earnings.
Assets
 
The funds obtained from issuing liabilities are used to acquire income-earning assets such as securities and loans.
Banks assets are referred to as uses to which funds are put, and theinterest payments earned on them are what enable banks to make profit.Asset side of the balance sheet includes
 
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Reserves
 Reserves include what banks keep with central bank plus currency(papers and coins) kept in the bank vaults.
Reserves are held for two reasons:
First, it is required by regulations that banks must keep afraction (required reserve ratio) of the money in their checkabledeposits as reserve. This is called required reserves.
Second, banks hold additional reserves, called excessreserves, to meet obligations when funds are withdrawn,directly by a depositors or indirectly when a check is written onan account.
o
 
Cash items in process of collection
.When a check written on an account at another bank is deposited inyour bank and the funds for this check has not been collected fromthe other bank, it is an asset for your bank because it is a claim onanother bank for funds that will be paid within a few days.
o
 
Deposits at other banks (corresponding banking)
 Many small banks hold deposits in larger banks in exchange for avariety of services, including check collection, foreign exchangetransactions, and help with securities purchase.
o
 
Securities
 A bank’s holdings of securities are an important income-earningasset.
o
 
Loans
 Banks make their profits primarily by issuing loans. Because of thelack of liquidity and higher default risk, the bank earns its highestreturn on loans.

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