Part 4: The Banking Industry

Chapter 4: The Economics of

Banking
Chapter Objectives

¤Understand The Bank Balance Sheet

¤Know the basic operations of a
commercial bank
¤Explain how banks manage risk
 1. The Bank Balance Sheet

¤A bank’s balance sheet provides a summary

of a bank’s sources and uses of funds
¤A typical bank balance sheet:
Assets (A) = Liabilities (B) + Bank Capital (C)
The Bank Balance Sheet

¤ A balance sheet is a statement that shows an individual’s

or a firm’s financial position on a particular day.

¤ An asset is something of value that an individual or a firm

owns; in particular, a financial claim

¤ A liability is something that an individual or a firm owes,

or, in other words, a claim on an individual or a firm.

¤ Bank capital is the difference between the value of a

bank’s assets and the value of its liabilities, also called
shareholders’ equity
 Table 1 The Consolidated Balance Sheet of
The Basics of Commercial Banking: The Bank Balance Sheet 281
US Commercial Banks (April 2010)
Table 10.1 The Consolidated Balance Sheet of U.S. Commercial Banks
Assets (uses of funds) Liabilities + Bank Capital (sources of funds)

(Percentage of
(Percentage of total liabilities
total assets) plus capital)
Reserves and other cash assets 7.5% Deposits 64.9%
Securities 19.9 Checkable deposits 5.6
U.S. government and agency 13.4 Nontransaction deposits 59.3
State and local government and 6.5 Small-denomination time
other securities deposits (CDs less than $100,000)
Loans 59.7 plus savings deposits 44.1
Commercial and industrial 9.6 Large-denomination time deposits
Real estate (including mortgages) 35.0 (CDs greater than $100,000) 15.2

Consumer 11.3 Borrowings 17.2

Interbank 1.1 From banks in the U.S. 1.5
Other loans 2.7 Other borrowings 15.7
Trading assets 1.5 Other liabilities 6.1
Other assets 11.4 Bank capital (or shareholders’ equity) 11.8
Note: The data are for all domestically chartered commercial banks in the United States as of April 28, 2010.
Source: Federal Reserve Statistical Release H.8, May 7, 2010.
The Bank Balance Sheet

¤Liabilities
¤Checkable deposits
¤Non-transaction deposits
¤Borrowings
¤Bank capital
The Bank Balance Sheet

¤Assets
¤Reserves and other cash assets
¤Securities
¤Loans
¤Other assets
 Bank Liabilities: Checkable Deposits

¤ Checkable Deposits: Accounts that depositors can

write checks. Also called transaction deposits.
¤ It is a liability, because it is money the bank owes to the
depositors should they demand their funds back.
¤ From the perspective of an individual person or firm holding
the checking account, checkable deposits are an asset.
¤ Typically two types of checkable deposits:
¤ Demand deposits: Checking accounts that do not pay
interest.
¤ NOW (Negotiable Order of Withdrawal) accounts:
checkable deposits that pay interest.
 Bank Liabilities: Non-transaction Deposits

¤ Non-transaction deposits: interest bearing deposit

accounts with restricted access to funds for the
depositors.
¤ Money market deposit accounts: interest bearing
accounts, depositors can write a limited number of
checks from this account per month.
¤ Savings accounts: interest bearing accounts, typically
have minimum balance or number of withdrawal
requirements.
¤ Time deposits or Certificates of deposit (CDs): deposit
accounts with specified maturity dates ranging from
several months to several years.
¤ Banks charge penalties for withdrawing funds prior to maturity date.
¤ Large denomination CDs (over $100,000) are negotiable, which means
they can be liquidated in a secondary market before maturity date.
 Bank Liabilities: Borrowings

¤ Federal funds borrowing: banks make literally overnight

loans to each other.
¤ Interest rate they charge is the federal funds rate
¤ Has nothing to do with federal government funds.
¤ Discount loans: banks can borrow funds from the
Federal Reserve, at the discount window.
¤ Repurchase agreements: banks sell something (i.e.
treasury bills) to another party, with an agreement to
purchase it back, usually the next day.
¤ Banks usually borrow from large corporations through this
channel.
 Bank Capital
¤ The final category on the liabilities side of the
balance sheet is bank capital, the bank’s net
worth (the difference between total assets and
liabilities)
¤ How to raise a bank capital?
¤ Selling new equity (stock)
¤ From retained earnings
¤ Bank capital is a cushion against a drop in the
value of its assets, which could force the bank
into insolvency
Bank Assets

¤ A bank uses the funds that it has acquired by

issuing liabilities to purchase income-earning
assets.

¤ Are referred to as “Uses of funds”

¤ “Income-earning assets” : the interest payments

earned on these assets allow banks to make
profits.
 Bank Assets: Reserves and Other
Cash Assets
¤ Reserves: vault cash plus deposits with the Federal Reserve.
¤ Vault cash: cash on hand, including cash held in banks’
vaults, cash held in ATMs, and deposits held with other
banks.
¤ Required reserves: The Federal Reserve requires banks to
hold a certain fraction of demand deposits and NOW
deposits in reserves.
¤ Required reserve ratio (RRR): percentage of demand and
NOW deposits the bank is required to keep on reserve.
¤ For deposits between $0 and $12.4 million, RRR = 0%.
¤ For deposits in excess of $12.4 million, and up to $79.5 million, RRR = 3%.
¤ For deposits in excess of $79.5 million, RRR = 10%.
¤ These ratios may change over time.
¤ Excess reserves: reserves banks hold in excess of the requirements of
Fed
Bank Assets: Reserves and Other
Cash Assets

¤ Cash items in the process of collection: claims

banks have on other banks for uncollected
funds

¤ Deposits at other banks: Small banks often

maintain deposits at other banks to obtain
other services such as foreign-exchange
transactions, check collection, or other services.
This is called correspondent banking.
 Bank assets: Securities

¤ Marketable securities: liquid assets that banks can

trade in financial markets.
¤ U.S. Treasury Bonds (often referred to as “secondary
reserves”)
¤ Other government and corporate bonds that received
investment-grade ratings when first issued.
¤ Limited amounts of municipal bonds.
¤ Not allowed to invest checkable deposits in corporate
bonds or common stock.
¤ Mortgage-backed securities: In 2010, made up 56% of
bank securities held.
 Bank Assets: Loans

¤ Loans:
¤ Largest category of banks’ assets.
¤ Illiquid.
¤ Banks earn higher interest than with marketable securities.
¤ Types of loans:
¤ Loans to businesses (or Commercial and Industrial (C&I)
loans).
¤ Consumer loans - loans to consumers to buy cars, furniture,
other crap.
¤ Real estate loans - residential mortgages.
¤ Real estate loans - commercial mortgages.
Bank Assets: Other Assets

¤ Repossessed collateral, including real estate

from borrowers who defaulted on their
loans.
¤ Bank’s physical assets, such as its own
buildings, office furniture, and computer
equipment.
in a decline in the value of their capital.

Problem: Constructing a Bank

Solved Problem 10.1
Balance Sheet
Constructing a Bank Balance Sheet
The following entries are from the actual balance sheet of a U.S. bank as of December 31, 2009.

Cash, including cash items in the process of collection $121

Non-interest-bearing deposits 275
Deposits with the Federal Reserve 190
Commercial loans 253
Long-term bonds (issued by the bank) 439
Real estate loans 460
Commercial paper and other short-term borrowing 70
Consumer loans 187
Securities 311
Interest-bearing deposits 717
Buildings and equipment 16
Other assets 685
Other liabilities 491
Values are in billions of dollars.

a. Use the entries to construct a balance sheet similar b. The bank’s capital is what percentage of its assets?
to the one in Table 10.1, with assets on the left side
of the balance sheet and liabilities and bank capital
on the right side.
PTER 10 • The Economics of Banking

Step 2 Answer part (a) by using the entries to construct the bank’s balance sheet,
remembering that bank capital is equal to the value of assets minus the
value of liabilities.
Assets Liabilities and bank capital
Cash including cash items in the $121 Non-interest-bearing deposits $275
process of collection
Deposits with the Federal Reserve 190 Interest-bearing deposits 717
Commercial loans 253 Commercial paper and other short- 70
term borrowing
Real estate loans 460 Long-term bonds 439
Consumer loans 187 Other liabilities 491
Securities 311 Total liabilities 1,992
Buildings and equipment 16 Bank capital 231
Other assets 685
Total assets $2,223 Total liabilities + bank capital $2,223

Step 3 Answer part (b) by calculating the bank’s capital as a percentage of its
assets.
Total assets = $2,223 billion
Bank capital = $231 billion $231 billion
Bank capital as a percentage of assets = = 0.104, or 10.4%
 Assets Liabilities and bank capital
Cash including cash items in the $121 Non-interest-bearing deposits $275
process of collection
Deposits with the Federal Reserve 190 Interest-bearing deposits 717
Commercial loans 253 Commercial paper and other short- 70
term borrowing
Real estate loans 460 Long-term bonds 439
Consumer loans 187 Other liabilities 491
Securities 311 Total liabilities 1,992
Buildings and equipment 16 Bank capital 231
Other assets 685
Total assets $2,223 Total liabilities + bank capital $2,223

Step 3 Answer part (b) by calculating the bank’s capital as a percentage of its
assets.
Total assets = $2,223 billion
Bank capital = $231 billion $231 billion
Bank capital as a percentage of assets = = 0.104, or 10.4%
$2,223 billion
For more practice, do related problem 1.8 on page 309 at the end of this chapter.

The Basic Operations of a Commercial Bank

ective In this section, we look at how banks earn a profit by matching savers and borrowers.
sic When a depositor puts money in a checking account and the bank uses the money to
 Basic Banking

¤ How do banks make profits?

=>Asset transformation process: banks make profits by

selling liabilities with one set of characteristics (a particular
combination of liquidity, risk, size, and return) and using the
proceeds to buy assets with a different set of characteristics.

¤ The process of transforming assets and providing a set of

services: If the bank produces desirable services at low
cost and earns substantial income on its assets, it earns
profits; if not, the bank suffers losses.
 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 bankʼs reserves equal to the
increase in checkable deposits
 Basic Banking: Check Deposit
When a bank receives
First National Bank
additional deposits, it
Assets Liabilities
gains an equal amount of reserves;
Cash items in +$100 Checkable +$100
process of deposits when it loses deposits,
collection it loses an equal amount of reserves

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100

deposits deposits
 Basic Banking: Making a Profit

First National Bank First National Bank

Assets Liabilities Assets Liabilities
Required +$10 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
 Bank Capital and Bank Profits
As with any other business, a bank’s profits are the difference between its revenues and
its costs. A bank’s revenues are earned primarily from interest on its securities and loans
and from fees it charges for services such as credit cards, servicing deposit accounts, and
terest margin The carrying out foreign exchange transactions. A bank’s costs are the interest it pays to its
nce between the
t a bank receives onBank Capital and Bank profit
urities and loans and
depositors, the interest it pays on loans or other debt, and its costs of providing its serv-
ices. A bank’s net interest margin is the difference between the interest it receives on its
erest it pays on securities and loans and the interest it pays on deposits and debt, divided by the total
ts and debt, divided value of its earning assets.1 If we subtract the bank’s cost of providing its services from
¤ Net interest margin The difference between the interest aThe bank
Basicaddreceives
Operations of a Commerc
total value ofon the fees itand
its its securities receives,
loans and the interest it pays on deposits andthe
divide the result by the bank’s total assets, and then bank’s
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g assets. divided by the total
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margin, of its
we have anearning
expressionassets.
for the bank’s total profitsThe earned per dollar of a Com
Basic Operations
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A which
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1Earning assets do not include assets, such
ROEas vault on which a. bank does not earn a return.
Bank capital
¤ ROA and ROE are related by the ratio ofbank’s
ROA and ROE are related by the ratio of a assets toassets
a bank’s its capital:to its capital:
ROA and ROE are related by the ratio of a bank’s assets to its capital:
Bank assets
ROE = ROA * Bank assets.
ROE = ROA * Bank capital .
Bank capital
At the end of April 2010, total assets of U.S. commercial banks were $11.9 trillion
andAtbank
the end of April
capital 2010,
was $1.4 total assets
trillion, meaningof U.S. commercial
that the bankstowere
ratio of assets $11.9
capital for trillion
the
Bank Capital and Bank profit

¤ Leverage A measure of how much debt an investor

assumes in making an investment.

¤ Bank leverage The ratio of the value of a bank’s assets to

the value of its capital, the inverse of which (capital to
assets) is called a bank’s leverage ratio.
 Bank Management

¤ Liquidity Management

¤ Asset Management

¤ Liability Management

¤ Capital Adequacy Management

¤ Credit Risk

¤ Interest-rate Risk
 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

¤ Suppose bankʼs required reserves are 10%

¤ If a bank has ample excess reserves, a deposit

outflow does not necessitate changes in other parts
of its balance sheet
 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
 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, such as Federal funds rate
 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
 Liquidity Management: 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
 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
 Asset Management: Three Goals

¤Seek the highest possible returns on loans

and securities
¤Reduce risk
¤Have adequate liquidity
 Asset Management: Four Tools

¤ Find borrowers who will pay high interest rates

and have low possibility of default
¤ Purchase securities with high returns and low risk
¤ Lower risk by diversifying
¤ Balance need for liquidity against increased
returns from less liquid assets.
 Liability Management

¤Recent phenomenon due to rise of

money center banks (large banks in key
financial centers)
¤Expansion of overnight loan markets and
new financial instruments (such as
negotiable CDs)
¤Checkable deposits have decreased in
importance as source of bank funds
 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
 Capital Adequacy Management:
Preventing Bank Failure
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
 Capital Adequacy Management:
Returns to Equity Holders

Return on Assets: net profit after taxes per dollar of assets

net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
= ×
equity capital assets equity capital
ROE = ROA × EM
 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
 Application: How a Capital Crunch
Caused a Credit Crunch in 2008

¤ Shortfalls of bank capital led to slower credit

growth
¤ Huge losses for banks from their holdings of
securities backed by residential mortgages.
¤ Losses reduced bank capital

¤ Banks could not raise much capital on a weak

economy, and had to tighten their lending
standards and reduce lending.
 Credit Risk: Overcoming Adverse
Selection and Moral Hazard

¤Screening and Monitoring

¤Screening
¤Specialization in lending
¤Monitoring and enforcement of
restrictive covenants
 Credit Risk: Overcoming Adverse
Selection and Moral Hazard

¤Long-term customer relationships

¤Loan commitments
¤Collateral and compensating
balances
¤Credit rationing
 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
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
 Interest Rate Risk: Gap Analysis

¤ Basic gap analysis:

(rate sensitive assets - rate sensitive liabilities) x Δ interest rates =

Δ in bank profit

¤ Maturity bucked approach

¤ Measures the gap for several maturity
subintervals.

¤ Standardized gap analysis

¤ Accounts for different degrees of rate sensitivity.
 Interest Rate Risk: Duration Analysis

%Δ in market value of security ≈ - percentage pointΔ in interest

rate x duration in years.

¤Uses the weighted average duration of a

financial institutionʼs assets and of its liabilities
to see how net worth responds to a change
in interest rates.
 Off-Balance-Sheet Activities

¤Loan sales (secondary loan participation)

¤Generation of fee income. Examples:
¤Servicing mortgage-backed securities.
¤Creating SIVs (structured investment
vehicles) which can potentially expose
banks to risk, as it happened in the
subprime financial crisis of 2007-2008.
 Off-Balance-Sheet Activities

¤Trading activities and risk management

techniques
¤Financial futures, options for debt
instruments, interest rate swaps,
transactions in the foreign exchange
market and speculation.
¤Principal-agent problem arises
 Off-Balance-Sheet Activities

¤Internal controls to reduce the principal-

agent problem
¤Separation of trading activities and book
keeping
¤Limits on exposure
¤Value-at-risk
¤Stress testing