The Banking Firm
Purpose of Chapter -- Introduction
to basic operations of the
individual bank.
Four types of Banks
Commercial Banks
Savings and Loans
Savings Banks
Credit Unions
The Bank’s Balance Sheet
Assets
Liabilities + Equity
Assets -- Market value of items in
your possession.
Liabilities -- Amounts owed to
other parties.
Equity = Assets - Liabilities
Working With Assets,
Liabilities, and Equity
Note: Definition of equity implies:
Assets = Liabilities + Equity
(Balance sheets balance!).
A Balance Sheet Example
Consider a house that you buy
worth $120,000. You take out a
mortgage of $100,000.
Assets
Liabilities + Equity
House $120,000 Mortgage $100,000
Equity
$20,000
The Bank’s Major
Liabilities and Equity
(1) Checkable Deposits (D)
Includes Demand Deposits,
Negotiable Order of Withdrawal
(NOW) Acounts, Automatic Transfer
of Savings (ATS) Accounts.
Not a major source of funds for
banks
(2) Nontransactions Deposits (T)
 Includes Savings Deposits, and
Small and Large Time Deposits
(Negotiable CDs)
 Major source of funds for banks -higher interest rate (cost), but less
frequency/more predictability of
withdrawal
(3) Borrowings (BORR) -- Funds
borrowed by banks, usually to
meet reserve requirements
Eurodollars
Repurchase Agreements Issued
Federal Funds borrowed
Discount Window Borrowings
(4) Equity (or Equity Capital) (E)
E = Total Assets - Total Liabilities
Increases with bank profits,
decreases with bank losses
Equity-Asset Ratio =
(Equity/Total Assets) -- measure of
bank’s health
The Bank’s Major Assets
(1)
Reserves (R) -- vault cash of
banks plus deposits at the
Federal Reserve
Interest earning, but interest rate
less than loan rates
Purpose: to back up withdrawals
from customer deposits
How much reserves to hold?
Profit versus safety
Reserve Requirements: The
“Minimum Safety Level”
Federal Reserve: issues reserve
ratios on checkable deposits (rD)
and savings and time deposits (rT)
with the provision that, at any time
R > rDD + rTT
Decomposition of Reserves
Required Reserves (RR),
RR = rDD + rTT
Excess Reserves (ER),
ER = R - RR
Equivalent Ways to Express
Reserve Requirement
R  RR, or ER  0
Other Assets
(2) Cash items in the Process of
Collection -- uncleared checks
(3) Deposits at Other Banks
(Correspondent Banking)
(4) Securities Holdings (B)
Holdings of Bonds, holding stock is
not allowed
Revenue source for banks
Short-term bonds -- “secondary
reserves”
Holdings include Negotiable CDs of
other banks
Long-term bonds -- can enjoy
conveniences of bonds
(5) Loans
Other major revenue source
Less liquid than bonds. For the
most part, the bank must hold
them until maturity
Higher default risk than bonds
(5) Loans, Continued
Preferred to bonds as a revenue
source for banks.
-- Inconveniences imply higher
interest rate
-- Personal aspect, tradition of
banking (US).
Distinction Between
Types of Banks (Loans)
Commercial Banks -- “Full Service
Banks”, any type of loan
Savings and Loans -- primarily
consumer mortgages
Savings Banks -- primarily consumer
mortgages and consumer loans
Credit Unions -- primarily consumer
loans (different tax treatment as well)
Fundamental
Balance Sheet Rule
Any customer withdrawal from
any of their deposits (checkable
deposits or savings and time
deposits) must be met with an
equal decrease in reserves.
An Example:
Customer Withdrawal
Customer withdraws $200 from
their savings deposit (T) at Chase
Chase
R - $200
T - $200
New Customer Deposits
Example: Customer deposits $300
in their checkable deposit (D)
Chase
R + $300
D + $300
Banks as
Financial Intermediaries
Financial Intermediary -- An institution
that borrows from lenders, then loans
to borrowers.
Takes advantage of institutional fact of
life -- lenders want to “lend small”, but
borrowers want to “borrow large”.
An Example -- The
Bank Increasing Its Profits
You make a $1000 mortgage
payment to Chase, $800 is interest
and $200 is payment to principal.
Interest paid on deposits: $300 to
holders of savings and time
deposits (T) and $50 to holders of
checkable deposits (D).
Balance Sheet Description
Chase
R + $1000
D + $50
L - $200
T + $300
E + $450
Bank Profit (E) = $800 - $350 = $450
A Banking Philosophy:
Liability Management
Liability Management -- Seek loan
demand, then finance it by issuing
CDs, or borrowing if under reserve
requirements.
Aggressive, profit-oriented policy,
followed mainly by large banks.
Liability Management:
Evidence
Negotiable CDs have become the
primary source of bank funds.
More bank borrowing (more outlets to
borrow as well).
Aggregate excess reserves are
generally close to zero.
Greater percentage of loans in asset
portfolio (less liquid, more default risk
than bonds).
The Bank’s Nightmares
Financial intermediaries have inherent
fundamental instabilities.
The bank can only reduce their probability of
occurrence and the impact if they do occur.
Bank regulation and regulatory agencies
seek as well to reduce the probability of
occurrence or reduce the impact to the bank
when they happen (next chapter).
Nightmare # 1 -Disintermediation
Disintermediation -- The
systematic withdrawal of customer
funds, which can create a minor or
major liquidity crisis.
Adverse effect of minor case:
bank slips below reserve
requirement.
The Bank Run:
The Most Dramatic Case
Consider the following balance
sheet situation (rD = 0.10, rT = 0.05).
Chase
R
$500
D $2000
L
$6500
T $6000
Bonds $2000
E $1000
Customers want 50% of D and 50%
of T (HELP!!).
Ways to Reduce Adverse
Effects: Disintermediation
Seek sufficient liquidity in asset
portfolio
Increase excess reserves for
anticipated unusual withdrawals
Be competitive
Use borrowing sources, when
needed
Nightmare #2 -Interest Rate Risk
Interest Rate Risk -- Increases in
interest rates (cost of funds) that
the bank cannot pass on to its
existing loans.
Creates reduced profits or even
losses on existing loans
Most risky -- fixed rate mortgages
(Savings and Loans!).
Ways to Reduce
Interest Rate Risk
Reduce the gap in maturity
between assets and liabilities
-- Promote shorter term loans
-- Promote longer-term deposits
Seek other sources of
income/profits
(“off the balance sheet” banking)
Nightmare #3 -Loan Default
Loan Default -- Borrower fails to repay loan
Declaring bankruptcy -- chapter 7
(consumers sell assets for discharge of
debts), as opposed to chapter 13 (debtor
arranges plan to repay debt).
Most frequent for consumers – credit card
balances (unsecured)
Default on mortgages – secured loans, but
could be a problem for banks if housing
prices have fallen significantly.
Example: Loan Default
Consider the following balance
sheet situation (rD = 0.10, rT = 0.05).
Chase
R
$500
D $2000
L
$6500
T $6000
Bonds $2000
E $1000
Equity-Asset Ratio
= (1000/9000) = 11.1%
The Balance Sheet
After a Loan Default
$500 loan default.
Chase
R
$500
D $2000
L
$6000
T $6000
Bonds $2000
E $500
Equity-Asset Ratio
= (500/8500) = 5.6%
Ways to Reduce Adverse
Effects of Loan Default
Screening/Collateral
Knowing clientele
Portfolio Diversification
Seek to maintain sufficiently large
equity-asset ratio
A Preview
of the Next Chapter
Bank regulation – how regulatory
agencies regulate the banking
system.
Wins and losses – US banking in
the postwar period, with recent
developments and current issues