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Econ2035

10.18.11

Chapter 9: The Business of Banking


I.
Banks Balance Sheet
Liabilities: amounts of money owed to others
Balance sheet: financial statement that summarizes an

entitys assets, liabilities, and net worth at a given date


Net worth (equity or capital): difference between assets and
liabilities
Liabilities and Net Worth
o Checking Deposits: This category covers deposits that
customers use to purchase goods and services.
o Nontransaction Deposits: These deposits cannot be
spent directly with checks or debit cards. However, they
pay higher interest rates than checking deposits.
Include savings deposits, and time deposits
(commonly called CDs for certificates of deposit.)
o Borrowings: A bank may want more fund than it raises
from deposits.
Federal Funds
Federal funds: loans from one bank to
another, usually for one day

Repo
Repurchase agreement (repo): sale of a
security with a promise to buy it back at a

higher price on a future date


Bonds

bonds are another means of borrowing


Loans from the Fed
Discount loan: loan from the Federal Reserve

to a bank
o Net Worth: The final item on the right side of the balance

sheet is net worth, or capital.


Assets

o Cash Items: This category includes several components,


which together comprised the 10 percent of bank assets in
2010.
Vault cash: currency in banks branches and ATMs
Reserves: vault cash plus bank deposits at the
Federal Reserve
o Securities: By law, banks are restricted to securities with
low risk. These include Treasury bonds, municipal bonds,
and corporate bonds or mortgage-backed securities.
Banks are not allowed to hold stocks or junk bonds.
Often called secondary reserves
o Loans: Loans are banks most important asset class.
Banks make loans to several types of borrowers:
consumers, businesses, governments, and other

banks.
Loans are less liquid than securities: it is hard to turn

them into cash quickly.


Loans can be profitable because they pay higher

interest rates than safe securities.


II.
Off-Balance-Sheet Activities
Off-balance-sheet (OBS) activities: bank activities that
produce income but are not reflected in the assets and liabilities

reported on the balance sheet


Lines of Credit: gives an individual or firm the right to borrow a

certain amount of money at any time


o Also called a loan commitment
Letters of Credit: a banks guarantee, in return for a fee, of a
payment promised by a firm
o Commercial letter of credit guarantees a payment for

goods or services.
o Standby letter of credit guarantees payments on a security.
Asset Management: wealth individuals hire banks to manage
assets, an activity called private banking.

Derivatives: large banks trade derivative securities such as

futures contracts and options on stocks, bonds, and currencies.


Investment Banking: some commercial banks provide
investment-banking services, such as underwriting securities and
advising on mergers and acquisitions.

III.
How Banks Make Profits?
Melvin Opens a Bank
The Income Statement
o Income statement: financial statement summarizing

income, expenses, and profits over some time period


Profit Rates
o Return on assets (ROA): ratio of a banks profits to its
assets;
ROA = profits/assets
o Return on equity (ROE): ratio of a banks profits to its
capital;
ROE = profits/capital
The ROE shows how much the bank earns for each
dollar its stockholders put in the business.

IV.
The Evolving Pursuit of Profits
Changes in Commercial Banking: Causes and Effects
o Competition from Securities Markets
Growth of mutual funds banks lose deposits
Development of junk bonds and commercial paper
fewer C&I loans
o Deregulation
Elimination of interest rate caps banks compete

with mutual funds, retain savings and time deposits


Repeal of Glass-Steagall banks offer investment

banking services
o Financial Innovation
Credit scoring and securitization more real estate

loans
Development of derivatives opportunities for

speculation
Sources of Funds

o Cheap and Expensive Funds


Core deposits: banks inexpensive sources of funds
(checking deposits, savings deposits, and small time

deposits)
Purchased funds: banks expensive sources of

funds (borrowing and large time deposits)


o A Two-Step Process
Banks raise funds in two steps:
1. They try to minimize core deposits
2. Banks choose their levels of purchased
funds

Seeking Income
o Commercial and Industrial (C&I) Loans
o Real Estate Loans
o Consumer Loans
o Off-Balance-Sheet Activities
All major types of lending

V.
Managing Risk
Liquidity Risk
o Liquidity risk: the risk that withdrawals from a bank will
exceed its liquid assets
o The LiquidityProfit Trade-Off: there is a simple way
to reduce liquidity risk: hold more liquid assets. The more
a bank holds, the less likely it will be to run out when

depositors make withdrawals.


o Short-term borrowing
Credit Risk
o Credit risk (default risk): the risk that loans will not be
repaid
Interest Rate Risk
o Interest rate risk: instability in bank profits caused by
fluctuations in short-term interest rates
o Measuring Interest Rate Risk
Rate-sensitivity gap: difference between ratesensitive assets and rate-sensitive liabilities
o Reducing Risk

Loan sales: loan sales can reduce credit risk and


interest rate risk. If a bank sells long-term loans, it
has fewer assets with fixed interest rates, so it can
acquire more rate-sensitive assets. The ratesensitivity gap moves closer to zero, making profits

more stable.
Floating Rates: interest rate on a long-term loan that

is tied to a short-term rate


Derivatives: Banks can hedge interest rate risk with
derivatives.
Ex: a bank can sell futures contracts for
Treasure bonds, a transaction that yields profits
if bond prices fall. Bond prices fall when
interest rates rise, so higher rates produce
profits for the bank. These profits offset the

loss arising from the rate-sensitivity gap.


Market and Economic Risk
o Market risk: risk arising from fluctuations in asset prices.
o Economic risk: risk arising from fluctuations in the
economys aggregate output
Interactions Among Risks
o The interactions risks mean that banks need to manage all
of them together.

VI. Insolvency
Insolvency: liabilities exceed assets, producing negative net
worth
o An insolvent bank cannot stay in business
o Insolvency hurts a banks stockholders, whose becomes
worthless, because the bank will have no future earnings.
o The Equity Ratio
Equity ratio (ER): ratio of a banks capital to its

assets;
ER = capital/assets
The Equity Ratio and the Return on Equity