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
CHAPTER
8
The Economics of Banking

WHAT HAPPENS WHEN LOCAL BANKS STOP LOANING MONEY?

• In the recovery from the financial crisis of 2007–2009, 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 2007–2009 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?
 8.1 Learning Objective
Understand bank balance sheets.
 • The key commercial banking activities are taking in deposits from savers and
making loans to households and firms.
• A bank’s primary sources of funds are deposits, and primary uses of funds
are loans, which are summarized in the bank’s balance sheet.

Balance sheet A statement that shows an individual’s or a firm’s 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 bank’s 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 bank’s 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 agreements—otherwise 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 businesses—called 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, 1973–2010
The types of loans granted by
banks have changed
significantly since the early
1970s.
Real estate loans have grown
from less than one-third 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 bank’s 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 bank’s capital equals the funds contributed by the bank’s shareholders
through their purchases of stock the bank has issued plus accumulated
retained profits.
• Note that as the value of a bank’s assets or liabilities changes, so does the
value of the bank’s 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 bank’s 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 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.

The Basics of Commercial Banking: The Bank Balance Sheet

Solved Problem 8.1
Constructing a Bank Balance Sheet

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
 
Bank capital as a percentage of assets

The Basics of Commercial Banking: The Bank Balance Sheet

 8.2 Learning 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 off 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 2007–2009, banks set aside enormous loan loss
reserves as they anticipated write-downs on mortgage-related 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 firm’s 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 bank’s total profits earned per dollar of assets is called
return on assets.

Return on assets (ROA) The ratio of the value of a bank’s after-tax profit to
the value of its assets.

The Basic Operations of a Commercial Bank

• To judge how a bank’s managers are able to earn on the shareholder’s
investment, we use the return on equity.

Return on equity (ROE) The ratio of the value of a bank’s after-tax profit to the
value of its capital.

• ROA and ROE are related by the ratio of a bank’s 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 bank’s 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 bank’s assets to the value of its
capital, the inverse of which (capital to assets) is called a bank’s leverage
ratio.

• A high ratio of assets to capital—high leverage—is 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

 8.3 Learning 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 borrowers—a 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 bank’s
profit or capital.

A rise (fall) in the market interest rate will lower (increase) the present value
of a bank’s 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 bank’s variable-rate assets and the dollar value of its variable-rate liabilities.

• Gap analysis is used to calculate the vulnerability of a bank’s profits to

changes in market interest rates.
• Most banks have negative gaps because their liabilities—mainly deposits—
are more likely to have variable rates than are their assets—mainly loans
and securities.

Managing Bank Risk

Duration analysis An analysis of how sensitive a bank’s capital is to changes
in market interest rates.

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