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Lesson

8
The Economics of Banking

LEARNING OBJECTIVES
After studying this lesson, you should be able to:
8.1

Understand bank balance sheets

8.2

Describe the basic operations of a commercial bank

8.3

Explain how banks manage risk

8.4

Explain the trends in the U.S. commercial banking industry

C H APT E R

8
The Economics of Banking

WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY?


In the recovery from the financial crisis of 20072009, banks had
become extremely cautious in making loans.
Banks were turning away borrowers with flawed credit histories and
avoiding industries that were hard hit by the recession.
As the value of real estate declined, the collateral that small businesses
could use to borrow against also declined.

Key Issue and Question


Issue: During and immediately following the 20072009 financial crisis,
there was a sharp increase in the number of bank failures.
Question: Is banking a particularly risky business? If so, what types of risks
do banks face?

8.1Learning Objective
Understand bank balance sheets.

The key commercial banking activities are taking in deposits from


savers and making loans to households and firms.
A banks primary sources of funds are deposits, and primary uses
of funds are loans, which are summarized in the banks balance
sheet.
Balance sheet A statement that shows an individuals or a firms
financial position on a particular day.

The typical layout of a balance sheet is based on the following


accounting equation:
Assets = Liabilities + Shareholders equity.

The Basics of Commercial Banking: The Bank Balance Sheet

The Basics of Commercial Banking: The Bank Balance Sheet

Asset Something of value that an individual or a firm owns; in


particular, a financial claim.

Liability Something that an individual or a firm owes, particularly a


financial claim on an individual or a firm.

Bank capital The difference between the value of a banks assets


and the
value of its liabilities; also called shareholders equity.

The Basics of Commercial Banking: The Bank Balance Sheet

Bank Liabilities
Checkable Deposits
Checkable deposits Accounts against which depositors can write
checks, also called transaction deposits.
Demand deposits are checkable deposits on which banks do not
pay interest.
NOW (negotiable order of withdrawal) accounts are checking
accounts that pay interest.
Checkable deposits are liabilities to banks and assets to
households and firms.

The Basics of Commercial Banking: The Bank Balance Sheet

Nontransaction Deposits
The most important types of nontransaction deposits are savings
accounts, money market deposit accounts (MMDAs), and time
deposits, or certificates of deposit (CDs).
Checkable deposits and small-denomination time deposits are
covered by federal deposit insurance.
CDs of less than $100,000 are called small-denomination time
deposits. CDs of $100,000 or more are called large-denomination
time deposits.
CDs worth $100,000 or more are negotiable, which means that
investors can buy and sell them in secondary markets prior to
maturity.
Federal deposit insurance A government guarantee of deposit
account
balances up to $250,000.
The Basics of Commercial Banking: The Bank Balance Sheet

Borrowings
Banks often make more loans than they can finance with funds
they attract from depositors.
Bank borrowings include short-term loans in the federal funds
market, loans from a banks foreign branches or other subsidiaries
or affiliates, repurchase agreements, and discount loans from the
Federal Reserve System.
Although the name indicates that government money is involved,
the loans in the federal funds market involve the banks own funds.
The interest rate on these interbank loans is called the federal
funds rate.
With repurchase agreementsotherwise known as repos, or RPs
banks sell securities, such as Treasury bills, and agree to
repurchase them, typically the next day. Repos are typically
between large banks or corporations, so the degree of
counterparty risk is small.
The Basics of Commercial Banking: The Bank Balance Sheet

Making the
Connection

The Incredible Shrinking Checking Account


Households hold less in
checking accounts
relative to other
financial assets than
they once did, partly
due to the wealth
effect.
As wealth has increased
over time, households
have been better able
to afford to hold assets,
such as CDs, where
their money is tied up
for a while but on which
they earn a higher rate
of interest.
The Basics of Commercial Banking: The Bank Balance Sheet

Bank Assets
Bank assets are acquired by banks with the funds they receive from
depositors, with funds they borrow, with funds they acquired initially
from their shareholders, and with profits they retain from their
operations.
Reserves and Other Cash Assets
Reserves A bank asset consisting of vault cash plus bank deposits
with the
Federal Reserve.
Vault cash Cash on hand in a bank; includes currency in ATMs and
deposits with other banks.

The Basics of Commercial Banking: The Bank Balance Sheet

Required reserves Reserves the Fed requires banks to hold against


demand deposit and NOW account balances.
Excess reserves Any reserves banks hold above those necessary to
meet reserve requirements.

Excess reserves can provide an important source of liquidity to


banks, and during the financial crisis, bank holdings of excess
reserves soared.
Another important cash asset is claims banks have on other banks
for uncollected funds, which is called cash items in the process of
collection.

The Basics of Commercial Banking: The Bank Balance Sheet

Securities
Marketable securities are liquid assets that banks trade in financial
markets.
Banks are allowed to hold securities issued by the U.S. Treasury
and other government agencies, corporate bonds that received
investment-grade ratings when they were first issued, and some
limited amounts of municipal bonds, which are bonds issued by
state and local governments.
Because of their liquidity, bank holdings of U.S. Treasury securities
are sometimes called secondary reserves.
In the United States, commercial banks cannot invest checkable
deposits in corporate bonds or common stock.

The Basics of Commercial Banking: The Bank Balance Sheet

Loans
The largest category of bank assets is loans. Loans are illiquid
relative to marketable securities and entail greater default risk and
higher information costs.
There are three categories of loans:
(1) loans to businessescalled commercial and industrial, or C&I,
loans;
(2) consumer loans, made to households primarily to buy
automobiles, furniture, and other goods; and
(3) real estate loans, including both residential and commercial
mortgages.
The development of the commercial paper market in the 1980s
meant that banks also lost to that market many of the businesses
that had been using short-term C&I loans.
The Basics of Commercial Banking: The Bank Balance Sheet

Loans

Figure
8.1
The Changing Mix of
Bank Loans, 19732010

The types of loans granted


by banks have changed
significantly since the early
1970s.
Real estate loans have
grown from less than onethird of bank loans in 1973
to two-thirds of bank loans
in 2010.
Commercial and industrial
(C&I) loans have fallen
from more than 40% of
bank loans to less than
20%.
Consumer loans have
fallen from more than 27%
of all loans to about 20%.
The Basics of Commercial Banking: The Bank Balance Sheet

Other Assets
Other assets include banks physical assets, such as
computer equipment and buildings. This category also
includes collateral received from borrowers who have
defaulted on loans.

The Basics of Commercial Banking: The Bank Balance Sheet

Bank Capital
Bank capital, also called shareholders equity, or bank net worth, is
the difference between the value of a banks assets and the value
of its liabilities.
In 2010, for the U.S. banking system as a whole, bank capital was
about 12% of bank assets.
A banks capital equals the funds contributed by the banks
shareholders through their purchases of stock the bank has issued
plus accumulated retained profits.
Note that as the value of a banks assets or liabilities changes, so
does the value of the banks capital.

The Basics of Commercial Banking: The Bank Balance Sheet

Solved
Problem

8.1

Constructing a Bank Balance Sheet


The following entries are from the actual balance sheet of a U.S.
bank as of December 31, 2009.

a. Use the entries to construct a balance sheet similar 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.
b. The banks capital is what percentage of its assets?
The Basics of Commercial Banking: The Bank Balance Sheet

Solved
Problem

8.1

Constructing a Bank Balance Sheet


Solving the Problem
Step 1 Review the lesson material.
Step 2Answer part (a) by using the entries to construct the
banks balance sheet, remembering that bank capital is
equal to the value of assets minus the value of liabilities.

The Basics of Commercial Banking: The Bank Balance Sheet

Solved
Problem

8.1

Constructing a Bank Balance Sheet


Step 3Answer part (b) by calculating the banks capital as a
percentage of its assets.

Total assets = $2,223 billion


Bank capital = $231 billion
Bank capital as a percentage of
assets

The Basics of Commercial Banking: The Bank Balance Sheet

8.2Learning Objective
Describe the basic operations of a commercial bank.

T-account An accounting tool used to show changes in balance sheet


items.
The
T-accounts below show what happens when you open a checking
account with $100 at Wells Fargo.

In this example, Wells Fargo uses its excess reserves to buy Treasury
bills worth $30 and make a loan worth $60.
The Basic Operations of a Commercial Bank

Making the
Connection

The Not-So-Simple Relationship between Loan Losses and


Bank
Profits
During
the term of the loan, if the bank decides that the borrower
is likely to default, the bank must write down or write of the loan.
Banks set aside part of their capital as a loan loss reserve to
anticipate future loan losses and avoid large swings in its reported
profits and capital from write-offs.
During the financial crisis of 20072009, banks set aside enormous
loan loss reserves as they anticipated write-downs on mortgagerelated loans.
The SEC has argued that banks will sometimes increase their loan
loss reserves more than is justified during an economic expansion,
when defaults are relatively rare. The banks can then draw down
the reserves during a recession, evening out their reported profits.
If true, this practice would amount to earnings management,
which is prohibited under accounting rules because it may give a
misleading view of the firms profits.
The Basic Operations of a Commercial Bank

Bank Capital and Bank Profits


Net interest margin The difference between the interest a bank
receives on its securities and loans and the interest it pays on
deposits and debt, divided by the total value of its earning assets.

An expression for the banks total profits earned per dollar of


assets is called return on assets.
Return on assets (ROA) The ratio of the value of a banks aftertax profit to the value of its assets.

The Basic Operations of a Commercial Bank

To judge how a banks managers are able to earn on the


shareholders investment, we use the return on equity.
Return on equity (ROE) The ratio of the value of a banks after-tax
profit to the value of its capital.

ROA and ROE are related by the ratio of a banks assets to its
capital:

The Basic Operations of a Commercial Bank

Managers of banks and other financial firms may have an incentive


to hold a high ratio of assets to capital.
The ratio of assets to capital is one measure of bank leverage, the
inverse of which (capital to assets) is called a banks leverage
ratio.
Leverage A measure of how much debt an investor assumes in
making an investment.
Bank leverage The ratio of the value of a banks assets to the
value of its capital, the inverse of which (capital to assets) is called
a banks leverage ratio.
A high ratio of assets to capitalhigh leverageis a two-edged
sword: Leverage can magnify relatively small ROAs into large
ROEs, but it can do the same for losses.

The Basic Operations of a Commercial Bank

Moral hazard can contribute to high bank leverage.


If managers are compensated for a high ROE, they may take
on more risk than shareholders would prefer.
Federal deposit insurance has increased moral hazard by
reducing the incentive depositors have to monitor the behavior
of bank managers.
To deal with this risk, government regulations called capital
requirements have placed limits on the value of the assets
commercial banks can acquire relative to their capital.

The Basic Operations of a Commercial Bank

8.3Learning Objective
Explain how banks manage risk.

Managing Liquidity Risk


Liquidity risk The possibility that a bank may not be able to meet
its cash needs by selling assets or raising funds at a reasonable cost.
Banks reduce liquidity risk through strategies of asset
management and liquidity management.
Asset management involves lending funds in the federal funds
market, usually for one day at a time.
A second option is to use reverse repurchase agreements, which
involve a bank buying Treasury securities owned by a business or
another bank while at the same time agreeing to sell the securities
back at a later date, often the next morning. These very short term
loans can be used to meet deposit withdrawals.
Liability management involves determining the best mix of
borrowings from other banks or businesses using repurchase
agreements or from the Fed by taking out discount loans.
Managing Bank Risk

Managing Credit Risk


Credit risk The risk that borrowers might default on their loans.
Diversification
By diversifying, banks can reduce the credit risk associated with
lending too much to a single borrower, region, or industry.
Credit-Risk Analysis
Credit-risk analysis The process that bank loan officers use to
screen loan applicants.
Banks often use credit-scoring systems to predict whether a
borrower is likely to default. Historically, the high-quality borrowers
paid the prime rate. Today, most banks charge rates that reflect
changing market interest rates instead of the prime rate.
Prime rate Formerly, the interest rate banks charged on six-month
loans to high-quality borrowers; currently, an interest rate banks
charge primarily to smaller borrowers.
Managing Bank Risk

Collateral
Collateral, or assets pledged to the bank in the event that the
borrower defaults, is used to reduce adverse selection.
A compensating balance is a required minimum amount that the
business taking out the loan must maintain in a checking account
with the lending bank.
Credit Rationing
Credit rationing The restriction of credit by lenders such that
borrowers cannot obtain the funds they desire at the given interest
rate.
Loan and credit limits reduce moral hazard by increasing the
chance a borrower will repay.
If the bank cannot distinguish the low- from the high-risk
borrowers, high interest rates risk dropping the low-risk borrowers
out of the loan pool, leaving only the high-risk borrowersa case
of adverse
selection.
Managing
Bank Risk

Monitoring and Restrictive Covenants


Banks keep track of whether borrowers are obeying restrictive
covenants, or explicit provisions in the loan agreement that
prohibit the borrower from engaging in certain activities.
Long-Term Business Relationships
The ability of banks to assess credit risks on the basis of
private information on borrowers is called relationship
banking.
By observing the borrower, the bank can reduce problems of
asymmetric information. Good borrowers can obtain credit at
a lower interest rate or with fewer restrictions.

Managing Bank Risk

Managing Interest-Rate Risk


Interest-rate risk The effect of a change in market interest rates on
a banks profit or capital.
A rise (fall) in the market interest rate will lower (increase) the
present value of a banks assets and liabilities.

Managing Bank Risk

Measuring Interest-Rate Risk: Gap Analysis and Duration


Analysis
Gap analysis An analysis of the difference, or gap, between the
dollar value of a banks variable-rate assets and the dollar value of its
variable-rate liabilities.
Gap analysis is used to calculate the vulnerability of a banks
profits to changes in market interest rates.
Most banks have negative gaps because their liabilitiesmainly
depositsare more likely to have variable rates than are their
assetsmainly loans and securities.

Managing Bank Risk

Duration analysis An analysis of how sensitive a banks capital is to


changes in market interest rates.
If a bank has a positive duration gap, the duration of the banks
assets is greater than the duration of the banks liabilities. In this
case, an increase in market interest rates will reduce the value of
the banks assets more than the value of the banks liabilities,
which will decrease the banks capital.

Managing Bank Risk

Reducing Interest-Rate Risk


Banks with negative gaps can make more adjustable-rate or
floating-rate loans. That way, if market interest rates rise and
banks must pay higher interest rates on deposits, they will also
receive higher interest rates on their loans.
Banks can use interest-rate swaps in which they agree to
exchange, or swap, the payments from a fixed-rate loan for the
payments on an adjustable-rate loan owned by a corporation or
another financial firm.
Banks have available to them futures contracts and options
contracts that can help hedge interest-rate risk.

Managing Bank Risk

8.4Learning Objective
Explain the trends in the U.S. commercial banking industry.

The Early History of U.S. Banking


The National Banking Act of 1863 made it possible for a bank to
obtain a federal charter.
National bank A federally chartered bank.
Dual banking system The system in the United States in which
banks are chartered by either a state government or the federal
government.

Trends in the U.S. Commercial Banking Industry

Bank Panics, the Federal Reserve,


and the Federal Deposit Insurance Corporation
The Federal Reserve plays the role of a lender of last resort by
making discount loans to banks suffering from temporary liquidity
problems.
Before the Fed existed, banks were subject to bank runs.
If many banks simultaneously experienced runs, the result would
be a bank panic, which often resulted in banks being unable to
return depositors money and having to temporarily close their
doors.
Bank panics typically resulted in recessions. After the severe bank
panic of 1907, Congress passed the Federal Reserve Act in 1913.
The Great Depression led to bank panics, and Congress responded
with the creation of the Federal Deposit Insurance Corporation
(FDIC), established in 1934.
Trends in the U.S. Commercial Banking Industry

Figure
8.2
Commercial Bank Failures in the United States, 19802010
Bank failures in the United States were at low levels from 1960 until the savings
and loan crisis of the mid-1980s. By the mid-1990s, bank failures had returned to
low levels, where they remained until the beginning of the financial crisis in 2007.

Trends in the U.S. Commercial Banking Industry

The Rise of Nationwide Banking


In the early 1900s, banks were prohibited from crossing state
lines. Unit banking meant that banks were kept small, serving
the local area.
In 1900, of the 12,427 commercial banks in the United States,
only 87 had any branches.
The U.S. system of many small, geographically limited banks
failed to take advantage of economies of scale in banking.
Restrictions on branching within the state loosened after the
mid-1970s, and in 1994, Congress passed the Riegle-Neal
Interstate Banking and Branching Efficiency Act, which
allowed for the phased removal of restrictions on interstate
banking.
These changes led to rapid consolidation of banks, from
14,384 in 1975 to only 6,839 by 2009. In 2010, concerns
about
size and banks
too
big to fail were discussed in
Trends
in thebank
U.S. Commercial
Banking
Industry
Congress, but no limits on size were finally enacted.

Trends in the U.S. Commercial Banking Industry

Expanding the Boundaries of Banking


Between 1960 and 2010, banks increased their funds and
borrowings; they relied less on C&I and consumer loans, and more
on real estate loans; they expanded into nontraditional lending
activities and activities generating revenue from fees instead of
interest.
Off-Balance-Sheet Activities
Off-balance-sheet activities Activities that do not affect a banks
balance sheet because they do not increase either the banks assets
or its liabilities.

Trends in the U.S. Commercial Banking Industry

Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come
to rely on to earn fee income include:
1. Standby letters of credit.
Standby letter of credit A promise by a bank to lend funds, if
necessary, to a seller of commercial paper at the time that the
commercial paper matures.
2. Loan commitments.
Loan commitment An agreement by a bank to provide a
borrower with a stated amount of funds during some specified
period of time.

Trends in the U.S. Commercial Banking Industry

Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come
to rely on to earn fee income include:
3. Loan sales.
Loan sale A financial contract in which a bank agrees to sell the
expected future returns from an underlying bank loan to a third
party.
4. Trading activities.
Banks earn fees from trading in the multibillion-dollar markets
for futures, options, and interest-rate swaps.
Bank losses from trading in securities became a concern during
the financial crisis of 2007-2009.

Trends in the U.S. Commercial Banking Industry

Electronic Banking
The first important development in electronic banking was the
spread of automatic teller machines (ATMs).
By the mid-1990s, virtual banks, or banks that carry out all their
banking activities online, began to appear.
By the mid-2000s, most traditional banks had also begun providing
online services.
Check clearing is now done electronically.

Trends in the U.S. Commercial Banking Industry

Making the
Connection

Can Electronic Banking Save Somalias Economy?


For a market economy to function, a government needs to
maintain a minimum level of order.
Banks are particularly vulnerable to robberies. Not
surprisingly, brick-and-mortar banks are scarce in Somalia,
which has been subjected to incessant civil wars and rampant
violence.
But for the past three years, Somali GDP has been growing,
and entrepreneurs have realized that they can provide virtual
banking services through cell phones and Internet access.
Somalis are now able to keep deposits online, transfer money,
and obtain credit.
While electronic banking appears to have contributed to the
welcome economic progress, the countrys other problems
present significant obstacles to maintaining that growth.

Trends in the U.S. Commercial Banking Industry

The Financial Crisis, TARP, and Partial Government


Ownership of Banks
As the financial crisis unfolded, residential real estate mortgages
began to decline in value.
The market for mortgage-backed securities froze, meaning that
buying and selling of these securities largely stopped, making it
very difficult to determine their market prices. These securities
became known as toxic assets.
Evaluating balance sheets and determining the true value of bank
capital was difficult.
Banks responded to their worsening balance sheets by tightening
credit standards for consumer and commercial loans. The resulting
credit crunch helped bring on the recession that started in
December 2007, as households and firms had increased difficulty
funding their spending.
Trends in the U.S. Commercial Banking Industry

Troubled Asset Relief Program (TARP) A government program


under which the U.S. Treasury purchased stock in hundreds of banks
to increase the banks capital.
Another initiative to inject capital into banks, called the Capital
Purchase Program (CPP), also relied on the U.S. Treasury to purchase
stock in hundreds of troubled banks.

Trends in the U.S. Commercial Banking Industry

Making the
Connection

Small Businesses: Key Victims of the Credit Crunch


Small businesses play a key role in the economy. Businesses with
fewer than 500 employees generate most of the jobs in the
economy.
During the financial crisis, banks were building their reserves and
tightening lending requirements, so it became increasingly
difficult for small firms to fund their operations.
As commercial real estate values declined, borrowing against the
value of stores or factories became more difficult.
Banks worried that the severity of the recession would increase
adverse selection and moral hazard. Pressure from government
regulators to avoid making risky loans and credit limits on credit
cards also limited the borrowing ability of small businesses.
The large employment losses during the recession came in part
from the difficulty of small businesses to obtain loans.

Trends in the U.S. Commercial Banking Industry

Answering the Key Question


At the beginning of this lesson, we asked the question:
Is banking a particularly risky business? If so, what types of risks do
banks face?
In a market system, businesses of all types face risks, and many fail.
Economists and policymakers are particularly concerned about the risk
and potential for failure that banks face because they play a vital role in
the financial system.
In this lesson, we have seen that the basic business of commercial
bankingborrowing money short term from depositors and lending it long
term to households and firmsentails several types of risks: liquidity risk,
credit risk, and interest-rate risk.

AN INSIDE LOOK AT POLICY

Interest-Rate Hikes Threaten Bank Profits


REUTERS, U.S. Regulators Warn Banks on Interest Rate Risk
Key Points in the Article
In early 2010, the Federal Financial Institutions Examination
Council (FFIEC) urged commercial banks to protect themselves
against a likely increase in interest rates.
Banks had profited by borrowing funds at low rates and purchasing
assets such as Treasury securities that had higher yields.
Some institutions are expecting interest rates to remain at historic
lows, but it is unlikely that the Fed will keep rates near zero forever.
As interest rates rise, banks relying heavily on short-term funds
could see their funding costs accelerate. Longer-term assets may
no longer be profitable to own, forcing banks to sell securities en
masse and potentially weakening the financial sector again.

AN INSIDE LOOK AT POLICY

Evidence of U.S. banks profits can be found in their balance sheets.


Bank capital as a percentage of assets was lower when interest rates
were higher prior to the financial crisis.