Lesson 9: The Business of Banking

Upon completion of this lesson, you should be able to do the following:

  • Identify a bank's assets, liabilities, and capital.
  • Describe how changes in a bank's balance sheet are recorded in T-accounts.
  • Explain how a bank may become insolvent.
  • Describe how interest rate risk affects a bank's balance sheet.

Introduction

This lesson focuses on the business of banking, because banks play a key role in the economy's payment system. Checking and savings accounts are very popular in the United States U.S. households invest about 1/4 of their wealth in banks. Most payments are made by check drawn from one bank and deposited into another bank.

Assets, Liabilities, and Capital

First, the bank's source of funds must be identified. All fund sources will be listed on a balance sheet. The balance sheet is a financial statement that lists all the bank's assets and liabilities. Assets are things a bank owns, while liabilities are things a bank owes to other people. Assets are listed on the left, while liabilities are listed on the right. Also they conform to the equation:

Total Assets = Total Liabilities + capital

Capital is total assets minus total liabilities. Capital has many names. It is also called net equity and net worth. All banks are organized into corporations. A corporate bank's net worth would be the stock sold to the investors and the bank's profit. If a bank failed and the bank paid all its liabilities, then the only thing that is left to the stockholders is net worth. Net worth is also important to the investors, because net worth can act like a cushion for bank losses. Usually net worth for banks average between 7 and 9% in the United States.

The first item on a bank's balance sheet is liabilities. Liabilities are the source of funds for a bank.

  1. Checkable deposits - this includes every form of checking account. If you needed money and went to a bank, the bank has to give you the money from your checking account immediately on demand. This is a liability to the bank, because the bank owes you this money. Checking accounts earn the lowest interest rate and are usually the cheapest source of funds for a bank.

  2. Nontransaction deposits - these deposits are the various types of savings accounts. These deposits require less bank services, and earn higher interest rates than checking accounts.

    1. Savings account - the most common, and pays a higher interest than interest on checking accounts.

    2. Money Market Deposit Accounts (MMDAs) - have limited check writing priviledges and pay higher interest than savings accounts.

    3. Time deposits or certificates of deposit - have maturities from several months to over 5 years. They are less liquid than savings account, but they pay higher interest. There are two types:

      1. Small-denomination - less than $100,000.

      2. Large-denomination time - values over $100,000, and are bought by corporations and other banks. They can be resold in a secondary market before maturity. So they are liquid and an alternative to T-bills.

  3. Borrowings - a bank will borrow funds if the bank can lend the funds to a borrower for a higher interest rate than the interest rate paid on the borrowings. Borrowings are not deposit accounts. Banks can borrow from the Federal Reserve or from other banks.

    • Discount loans - the loans from the Federal Reserve.

    • Federal funds market - each bank is required to hold cash in the vault or deposits at the Federal Reserve and the amount is based on the percentage of deposits a bank has. If one bank has excess deposits at the Fed and another bank has a shortage of deposits at the Fed, then the bank with the excess deposits can loan the excess funds to the other bank. This is the federal funds market and usually it is an overnight loan. The interest rate for this market is called the federal funds rate.

The second item on a bank's balance sheet is assets. The bank will take funds from depositors and will loan these funds. These loans are assets earn interest and earn interest. This is the source of income for the bank.

  1. Reserves - the reserves are composed of three items.

    1. Vault cash - is simply cash the bank has in its safe. A bank has money, so the bank can pay meet a depositor's account withdrawal.

    2. A bank will hold deposits at another bank, because these deposits can help check clearing and are also used in foreign exchange transactions.

    3. Banks hold deposits the Federal Reserve. Banks are legally required to hold a percentage of the bank's checkable deposits. This is called required reserves. The Federal Reserve wants to ensure that banks have enough reserves to meet depositors' withdrawal demands.

  2. Marketable securities - banks hold U.S. government securities, such as T-bills, T-notes, T-bonds, and municipal bonds. These securities are very liquid and are sometimes called secondary reserves. If banks need more reserves fast, then the bank can easily sell its marketable securities.

  3. Loans - the most important source of income. In 1998, loans represented roughly 67% of total assets. Loans have higher probability of default than other assets, a lower liquidity, and more information costs. However, banks are compensated for this risk by earning higher interest rates. Loans earn higher interest rates than marketable securities. The majority of loans are for commercial and industrial loans, and mortgages.

  4. Miscellaneous Assets - earn no interest and include physical capital, such as the bank's building, computers, and other equipment.

Determining Bank Profits through T-Accounts

A bank can develop financial problems and fail. This is called a bank failure. The bank is not able to return all money to the depositors. Government regulations encourage banks to hold a large amount of reserves, marketable securities, and equity capital, which decrease the chance of bank failures.

In this analysis, T-accounts will be used. A T-account is a simplified balance sheet and only lists changes on the balance sheet. For example, you open a checking account at your bank and deposit $100 cash. The transaction is recorded as:

Your Bank

Assets Liabilities
+$100 Reserves +$100 Checking account

The central bank requires commercial banks to hold a required reserve ratio of 10% in the form of vault cash and/or reserves at the central bank. Therefore, $10 of your money becomes required reserves and the remaining become excess reserves. Excess reserves are funds the bank has and can loan these funds to borrowers. The transaction is recorded below:

Your Bank

Assets Liabilities
+$10 Required reserves

+$90 Excess reserves

+$100 Checking account

The bank earns no interest on reserves, so the bank makes a loan to someone for $90. The loan is the bank's source of income. The transaction is recorded below:

Your Bank

Assets Liabilities
+$10 Required reserves

+$90 Loans

+$100 Checking account

For the bank to earn a profit, the bank has to earn a higher interest rate on the loan than the amount of interest the bank is paying on your checking account. What happens if the borrower defaults and does not repay the loan. The bank is still obligated to pay your $100 back, when you demand it. The $90 would come from the bank's net worth and $10 from required reserves.

How a bank manages liquidity risk is very important. Liquidity risk is the possibility that depositors may withdraw more money from their accounts than the amount of cash in a bank's vault. Banks developed two strategies to prevent liquidity risk.

  1. Asset management - first, banks look for borrowers, who will pay high interest rates and not default on their loans. Second, banks purchase securities that have high returns, are very liquid, and have low risk. If depositors withdrawals are very high, the banks can easily cash in the liquid securities.

  2. Liability management - banks cannot force customers to open checking and savings accounts. Banks cannot influence these funding sources. Through innovation, banks created new financial instrument, which opened new funding sources, such as certificates of deposits, Eurodollars, federal funds market, and repurchase agreements. Now banks are not restricted in raising funds.

The first example shows liquidity risk for your bank and your bank's balance sheet is listed below. The Federal Reserve requires your bank to hold 10% of deposits as required reserves. The bank should have enough funds to meet depositors' withdrawals.

Your Bank

Assets Liabilities
Required reserves $10 million

Excess reserves $10 million

Loans $80 million

Securities $10 million


Deposits $100 million

Bank Capital $10 million

Depositors withdraw $10 million. Deposits will decrease by $10 million, and the bank pays the funds from excess reserves, which is $10 million. This bank has met withdrawal demands. Both bank deposits and excess reserves decrease by $10 million. Below shows changes to the balance sheet.

Your Bank

Assets Liabilities
Required reserves $10 million
Excess reserves $0 million
Loans $80 million
Securities $10 million

Deposits $90 million
Bank Capital $10 million

Depositors now withdraw another $10 million. Now the bank has no required reserves. Both deposits and required reserves decrease by $10 million. The bank is still required to hold 10% of deposits as reserves. The bank needs to find $8 million. The bank has the following three options:

  • The bank sells $8 million of securities.

  • The bank reduces loans by $8 million by calling loans in or selling the loans to other banks.

  • The bank borrows the funds from the central bank or another commercial bank.

Your Bank

Assets Liabilities
Required reserves $0 million
Excess reserves $0 million
Loans $80 million
Securities $10 million

Deposits $80 million
Bank Capital $10 million

Your bank decides to borrow the $8 million from the Federal Reserve as a loan. Your bank managed the liquidity risk well. Below is how the balance sheet changes.

Your Bank

Assets Liabilities
Required reserves $8 million
Excess reserves $0 million
Loans $80 million
Securities $10 million
Deposits $80 million
Bank Capital $10 million
Fed loan $8 million

How does a bank prevent a bank failure? A bank holds excess reserves and short-term, highly liquid securities to prevent a bank failure. Let's show another example where your bank fails. Your bank has the following balance sheet below.

Your Bank

Assets Liabilities
Required reserves $10 million
Excess reserves $0 million
Loans $90 million
Securities $10 million

Deposits $100 million

Bank Capital $10 million

Your bank has $40 million of loans go into default, because the economy entered a recession. The depositors become fearful of a bank failure and withdraw $20 million from their accounts. The bank pays the depositors from required reserves and by selling the securities. Your bank is now insolvent. Total liabilites exceed total assets, so your bank has a potential for failing.

Your Bank

Assets Liabilities
Required reserves $0 million

Loans $50 million
Deposits $80 million

Bank Capital $10 million

As you can see from the previous example, a bank can fail if too many loans go bad. A bank is very concerned about credit risk. Credit risk is the risk that borrowers will default on their loans. One method banks use to lower credit risk is by diversify their loan portfolios. Banks spread out their loans among different industries, different regions, and different loan types. For example, a bank may grant loans for credit cards, mortgages where the homes are spread out in the state, and different types of commercial loans such as a loans for hotels, restaurants, retail stores, and factories. If a factory bankrupts and defaults on its commercial loan, the bank is not harmed. The bank is earning income on the other loans.

Adverse selection is a problem for banks. Some borrowers will apply for loans at banks, when the borrowers know they will have a high chance of defaulting. The banks implement five procedures to prevent adverse selection.

  1. Credit-risk analysis - the bank will collect information about the borrowers' employment, income, and net worth. From this information the bank assesses the borrowers' ability to repay the loan.

  2. Collateral - borrowers pledge assets to the bank. If the borrowers defaults on the loan, the bank will seize the asset. For example, the collateral for a mortgage is the house. If the homeowner defaults on the mortgage, then the bank takes the house.

  3. Credit rationing - banks establish a maximum amount of loan for a borrower. For example, credit cards for college students usually have a maximum credit of $1,000. If the credit limit was $10,000, then some students may use the credit card too much and not be able to pay the credit card balance.

  4. Restrictive covenants - conditions specified in the loan agreement. These conditions prevent the borrowers from engaging in certain activities. For example, a person applies for a home improvement loan, but wants to use the loan to speculate in the derivatives market. The bank will put a restrictive covenant in the loan agreement. The loan can only be used for home improvement.

  5. Long-term relationship with the borrowers - when banks know the customers well, they can accurately assess the customers' risk of default.

Interest Rate Risk

With increased volatility of interest rates in the 1980s, banks became more concerned with interest rate risk. Banks experience interest rate risks, when changes in the interest rates cause the banks' profit to fluctuate. Look at the bank's balance sheet below:

Your Bank

Assets Liabilities
Interest rate sensitive assets: $20 million
  • Variable-rate loans
  • Short-term securities

Fixed-rate assets: $80 million

  • Long-term bonds
  • Long-term securities
Interest rate sensitive liabilities: $50 million
  • Certificates of deposit
  • Money market deposit accounts

Fixed-rate liabilities: $50 million

  • Checkable deposits
  • Savings accounts

Interest-rate sensitive items are short-term securities, variable interest-rate loans, and short-term deposits. When the interest rate changes, the interest rate on the sensitive items change almost immediately. The fixed-rate assets and liabilities are not sensitive to interest rate changes. These loans and securities are locked into one interest rate for a very long time. Checking and savings accounts are considered fixed-rate liabilities, because these accounts pay little or no interest.

If interest rates increase from 10% to 15%. (A 5% interest increase). The income on interest-rate sensitive assets increases by $1 million. ( 0.05 * $20 million = $1 million). The cost of funds increases by $2.5 million. (0.05 * $50 million = $2.5 million). The bank's profits now decrease by $1.5 million. ($1 M - $2.5 M = -$1.5 M). Changes in the interest rates can have a very big impact on a bank's profits. There are three conditions that can occur when interest rate changes:

  • If interest-rate sensitive liabilities > interest-rate sensitive assets, an increase in the interest rates cause bank profits to decrease, while a decrease in interest rates cause bank profits to increase.

  • If interest-rate sensitive liabilities < interest-rate sensitive assets, you get the exact opposite from the first condition.

  • If interest-rate sensitive liabilities = interest-rate sensitive assets, then changes in interest rates does not change bank profits.

For example, if the bank manager knows that interest-rate sensitive liabilities > interest-rate sensitive assets and he believes interest rates will fall, then he will do nothing. The bank manager expects the bank's profit to increase. If the bank manager thinks interest rates will increase, then he will try to increase interest-rate sensitive assets and decrease interest-rate sensitive liabilities by manipulating the items on the balance sheet.

Over the last 20 years, there has been three factors that changed how a bank manages its balance sheet.

  1. Deregulation - the U.S. federal government deregulated the financial markets, giving banks more flexibility in acquiring assets and liabilities.

  2. Financial innovation - new financial instruments were created that are more liquid, such as repurchase agreements and federal funds market. Banks use securitization to transform bank loans into liquid securities.

  3. High volatility of interest rates - during the 1980s contributed to the new financial instrument being created. One innovation was floating-rate debt. Some banks started granting loans to borrowers that have variable interest rates. If interest rates increase, the banks can increase the interest rate on the loans. Therefore, banks are not harmed by interest rate changes. The derivatives market also expanded during the 1980s. Banks would buy futures and options to protect themselves from changing interest rates.

Securitization

Securitization is very similar concept to the mutual funds. Securitization is the process of transforming otherwise illiquid financial assets into marketable securities. The banks take similar loans, such as mortgages, pool them together into one fund, and issue securities that are based on this fund to investors. On average, the pool of funds have a predictable cash flow and as people pay their loans, some of this money is returned to the investors of the fund. Securitization is possible, because of computers, which makes the record keeping process simple. Banks have turned the following loans into marketable securities:

• Mortgages.
• Car loans.
• Third world debt.
• Credit cards.
 

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