Chapter 8 How Banks Work

Chapter Eight
1 How Banks Work
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2
The Role of Banks

 A bank is a financial intermediary that accepts
deposits from savers and makes loans to
borrowers.
 By making larger loans out of small deposits,

banks provide liquidity for borrowers and
lenders.
 Banks are adept at:

a) pooling funds
b) gathering information about borrowers
3
Asymmetric Information
 Both borrowers and lenders want to paint the best possible picture
when presenting themselves to banks.
 Asymmetric information is a situation where one party to a transaction
knows more, has more information, than the other.
 Two types of problems result:
• Adverse selection
• Moral hazard
4
Adverse Selection
• Those at more than average risk are also more likely
to enter a contract that is offered to everyone.
• Example: the market for “lemons” The market for

used cars contains cars of lower than average quality.
• The least desirable (highest risk) borrowers are the

most likely to accept loans at high interest rates.
5
Moral Hazard
 The mere existence of a contract can change people’s behavior,
incentivizing them to behave in ways they otherwise might not.
 Example: car insurance. The sense of security provided may

induce people to drive more recklessly than they would without it.
 Borrowers may behave in ways that harm the bank, taking on

more risk in order to get a loan than they would with their own
capital.
Solutions to Asymmetric
6
Information Problems
Banks have means to minimize the problems
posed by asymmetric information.
• Collateral can be accepted from borrowers, reducing
borrowers’ incentive to engage in risky practices.
• Borrowers can be required to maintain a minimum net
worth, below which loans must be paid immediately.
• Covenants can be inserted in loans to require
borrowers to behave in certain ways.
7
Failures of the Banking System

 The Savings-and-Loan Crisis: Undiversified portfolios
and insecure long-term loans resulted in high
risk of failure. A moral hazard problem was
created by the government with new loans
allowing for additional expansion.
 The Credit Crunch of the 90s: Banks lent less than normal
with greater requirements of borrowers. Banks
scrambled to add other assets to their portfolios,
reducing the potential for capital investment in
the economy.
8
The Financial Crisis of 2008

• Declining housing prices led to mortgage
defaults.
• Large financial firms needed bailouts.
• Causes: loose mortgage lending standards and

highly leveraged financial firms.
• Troubled Asset Relief Program (TARP) was one

response by the government.
9
Bank Balance Sheets

 The profit motive guides the bank’s decisions regarding
how much to lend and to whom.
Assets = liabilities + equity capital
 Assets primarily include reserves, securities, and loans

the bank has made.
 Loans represent the asset generating the greatest profit.
 Liabilities include primarily savers’ deposits and
borrowing on behalf or the bank.
Bank Balance Sheets (cont’d)
10
Banks must balance each side of the balance

sheet, such that assets = liabilities + capital
Example: A saver’s deposit simultaneously

increases reserves (asset) and transactions
deposits (liability).
Example: A bank’s purchase of government

securities increases securities (asset) and
decreases reserves (asset).
11
Reserve Accounting
Banks manage funds by adjusting the size of their reserves.
By law, banks are required to maintain a certain amount of reserves.
Reserves = vault cash + deposits at the Fed
Table 8.1 Reserve Requirements for 2013
12
Excess Reserves
• Banks often keep more reserves on hand than is
necessary to meet their requirements.
• Excess reserves are the bank’s total reserves minus its

required reserves.
• Excess reserves are used in five ways:

1) held by the bank, earning interest from the Fed
2) lent in the federal funds market
3) deposit at the Fed’s Term Deposit Facility
4) used to buy securities
5) used to make new loans
13
The Federal Funds Market
• The federal funds market is the where banks
lend excess reserves to other banks desiring
additional reserves.
• The interest rate charged on these inter-bank

loans is the federal funds rate.
• If a bank has any amount in deposit at the Fed, it

may loan in the federal funds market.
• Small banks often carry excess reserves only as

vault cash, precluding them from this market.
14
Insufficient Reserves
 When banks cannot make their reserve

requirement, they are faced with five options:
1) borrowing in the federal funds market
2) borrowing from the Fed at the discount window
(borrowing directly from the Fed at the discount rate)
3) selling securities owned by the bank
4) reducing outstanding loans
5) issuing certificates of deposit
15
Spread & Bank Profits
Most profit comes from interest paid to the bank on
loans and securities.
Additional profits are earned through bank fees and

services.
The size of a bank’s profit depends on the spread, or

the difference between the average interest earned on
its assets and the average interest paid on its
liabilities.
Banks & Competition
16
• As in all industries, competition keeps banks’

prices (i.e., interest rates) similar across banks.
• More competition = smaller spread
• Banks with large volumes can take advantage of

economies of scale.
17
Banks & Risk
Like all businesses, banks’ profits are not

guaranteed, but tempered by risk.
• Default risk, also called credit risk, is the possibility that
the bank’s borrowers do not repay their loans.
• Interest rate risk is the risk that changes in market interest
rates decrease the value of the bank’s financial assets.
Risk is reduced through internal controls and audits,

diversification of holdings, and active management
of assets and liabilities.
18
Interest on Reserves
• In 2008 Congress authorized the Fed to
pay interest on banks’ reserve balances.
• Reserves increased dramatically.
• Paying interest on reserves is another

tool that the Fed can use to affect the
money supply.
Bank Reserves Figure 8.1 Bank Reserves
19
Bank reserves increased dramatically during the financial crisis

of 2008.

Chapter 8 How Banks Work

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Chapter Eight

1 How Banks Work

The Role of Banks

 By making larger loans out of small deposits,

 Banks are adept at:

• Example: the market for “lemons” The market for

• The least desirable (highest risk) borrowers are the

 Example: car insurance. The sense of security provided may

 Borrowers may behave in ways that harm the bank, taking on

Failures of the Banking System

The Financial Crisis of 2008

• Large financial firms needed bailouts.

• Causes: loose mortgage lending standards and

• Troubled Asset Relief Program (TARP) was one

Bank Balance Sheets

Assets = liabilities + equity capital

 Assets primarily include reserves, securities, and loans

Banks must balance each side of the balance

Example: A saver’s deposit simultaneously

Example: A bank’s purchase of government

By law, banks are required to maintain a certain amount of reserves.

Reserves = vault cash + deposits at the Fed

Table 8.1 Reserve Requirements for 2013

• Excess reserves are the bank’s total reserves minus its

• Excess reserves are used in five ways:

• The interest rate charged on these inter-bank

• If a bank has any amount in deposit at the Fed, it

• Small banks often carry excess reserves only as

 When banks cannot make their reserve

Additional profits are earned through bank fees and

The size of a bank’s profit depends on the spread, or

• As in all industries, competition keeps banks’

• More competition = smaller spread

• Banks with large volumes can take advantage of

Banks & Risk

Like all businesses, banks’ profits are not

Risk is reduced through internal controls and audits,

• Reserves increased dramatically.

• Paying interest on reserves is another

Bank reserves increased dramatically during the financial crisis

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