Chapter 9
Banking and
the Management
of Financial
Institutions
Preview :
• This chapter examines how banks attempt
to maximize their profits.
• Although the discussion that follows
focuses primarily on commercial banks,
many of the same principles apply to other
financial intermediaries as well.
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Learning Objectives:
• Summarize the features of a bank balance sheet.
• Apply changes to a bank’s assets and liabilities
on a T-account.
• Identify ways in which banks can manage their
assets and liabilities to maximize profit.
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The Bank Balance Sheet:
– It is a list of the assets and liabilities of the bank
Total assets = Total liabilities + Capital
Bank liabilities : sources of funds for the bank .
Bank assets : uses of funds acquired by the bank.
Note that:
• Banks obtain funds by borrowing and by issuing other
liabilities, such as deposits.
• They then use these funds to acquire assets such as securities
and loans.
• Bank makes profits by earning interest on its assets higher
than interest and other expenses on its liabilities.( the i banks
receive higher than the i banks pay)
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The Bank Balance Sheet: Cont’d :
• Liabilities: they are (sources of funds)
• The funds obtained from issuing liabilities are used to
purchase income earning assets.
• They are primarily :
- Checkable deposits
- Non-transaction deposits.
- Borrowings.
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Liabilities:
1. Checkable deposits:
They are bank accounts that allow the owner of the
account to write checks on them.
• They are payable on demand : that is, if a depositor
shows up at the bank and requests payment by making
a withdrawal, the bank must pay the depositor
immediately.
• They are assets for depositors and liabilities for the
bank : an asset for the depositor because it is part of
his or her wealth, because the depositor can withdraw
funds and the bank is obligated to pay, checkable
deposits are a liability for the bank.
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Liabilities:
1. Checkable deposits:
• They are usually the lowest – cost source of bank
funds: because depositors are willing to forgo some
interest in exchange for access to a liquid asset that
they can use to make purchases immediately.
•The bank costs of maintaining checkable deposits :
include interest payments and cost of servicing these
accounts such as processing, preparing , and sending out
monthly statements; providing efficient tellers (human or
otherwise); advertising & marketing .
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1.Checkable deposits:
• Types:
➢ Non-Interest Bearing Checking Accounts
➢ Interest-Bearing Checking Accounts- Negotiable
Order of Withdrawal (NOW) ( some banks in USA
pay very low interest on some checkable deposits)
➢ MMDAs (money market deposit accounts: accounts
used by banks to buy securities from the money market
and pay the depositor some interest)
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Liabilities : Cont’d :
2. Non-transaction deposits:
They are the primary source of bank funds. owners can not
write checks on them.
•Owners cannot write checks on non-transaction deposits but , the
interest rates paid on them are usually higher than those of
checkable deposits .
•There are two basic types of non-transaction deposits saving
accounts and time deposits “CDs”.
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2. Non-transaction deposits:
❖Saving accounts :
They are the most common type of non-transaction
deposits.
•Funds can be added to or withdrawn from them at
any time .
•Transactions and interest payments are recorded in a
monthly statement or a passbook held by the owner of
the account.
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❖Time deposits:
•They have a fixed maturity length, ranging from several
months to over five years and assess substantial penalties for
early withdrawal of funds .( such as losing an amount of the
interest payment)
Types:
• Small denomination time deposits < 100,000 dollars : they are
less liquid than saving accounts but earn higher interest rates
and more costly source of fund for the bank.
•Large denomination time deposits are available in
denominations of 100,000 or more and are bought mainly by
corporations and other banks.
They are negotiable (resold in secondary markets before they
mature).
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Liabilities : Cont’d :
3. Borrowings:
Bank can obtain funds by borrowing from:
• CB (The Federal Reserve System
• Reserves overnight of other banks in the federal fund
market. Interbank loans(The Federal Funds).
• Parent companies (bank holdings companies)
( a large financial corporation that owns a bank or more
or other financial institutions)
• Loan arrangements with corporations (like
repurchase agreements :REPOs).
• Borrowings of Eurocurrencies .
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Bank capital:(Net worth of the bank) :
It equals the difference between total assets and
liabilities .
• Bank capital can be raised:
➢ by selling new equity (stocks of the bank itself).
➢or from retained earnings.
• It is the bank cushion against a drop in the value of
its assets which occurs when a bank has liabilities in
excess of assets (the bank can be forced into
liquidation).
• Secures against Insolvency (L>A → liquidation)
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The Bank Balance Sheet: Cont’d :
•Assets: They are the (uses of funds).
• A bank uses the funds that it has acquired by
issuing liabilities to purchase income earning assets,
to make profits.
• They are composed of :
– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets
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Assets :
1.Reserves:
All banks hold some of the funds they acquire as reserves .
•Reserves consists of:
(deposits held at The CB (Fed) + currency physically held by
banks called vault cash).
•Required reserves :they are held because of reserve
requirements , the regulation that for every dollar of checkable
deposits at a bank, a certain percentage must be kept at CB as
reserves and this percentage is called : Required reserve ratio.
•Excess reserves:(additional reserves) they are the most liquid of
all bank assets and bank can use them to meet its obligations.
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Assets : Cont’d :
2. Cash items in process of collection:
When a check is written on an account at another
bank is deposited in your bank ,and the funds for
this check have not yet been received (collected)
from the other bank.( my bank is Al Ahly bank
and I received a check written on Misr Bank. So I
give it to my bank( Al-Ahly to collect its value
from Misr bank and deposit it in my account. )
• It is an asset for your bank because it is a
claim on another bank for funds that will be
paid within a few days.
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Assets : Cont’d :
3. Deposits at other banks:
•Small banks hold them in large banks in exchange for
services (correspondent banking).(small banks keep
deposits in large banks so as large banks do some
banking services for them such as:)
➢Check collection.
➢Foreign exchange transactions.
➢Help with securities marketing.
➢Securities purchases.
In the assets:
•Cash items in process of collection + deposits at other
banks → cash items
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Assets : Cont’d :
4 . Securities:
• A bank’s holdings of securities are an important
income-earning asset: Securities (made up entirely
of debt instruments for commercial banks, because
banks are not allowed to hold stock)
• They can be classified into three categories:(USA)
a. The U.S government and agency securities.
b. State and local government securities ( they are less
liquid and riskier than U.S government securities ).
c. Other securities.
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Assets : Cont’d :
4 . Securities: Cont’d:
• The U.S. government and agency securities are the
most liquid because they can be easily traded and
converted into cash with low transaction costs.
• Because of their high liquidity, short-term U.S.
government securities ( treasury bills) are called
secondary reserves.
then , to sum up :
• Treasury Bills are secondary reserves due to :
➢ Easily traded
➢ Converted into cash with low transaction costs
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Assets : Cont’d :
5. Loans:
Banks make their profits primarily by issuing loans.
A loan is a liability for the individual or corporation receiving
it, but an asset for a bank, because it provides income to the bank.
Banks earn their highest return on loans
because:(Lack of liquidity and the higher default risk)
as:
• Loans are less liquid than other assets as they can
not be turned into cash until the loan matures.
• Loans have higher probability of default than other
assets .
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Assets : Cont’d :
6. Other assets:
The physical capital ( bank buildings ,
computers and other equipment ) is
included in the other assets category.
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The Commercial Bank Balance Sheet.
Commercial Bank T-Account
Assets
Liabilities
Reserves
cash items in process
Checkable deposits
Securities
Non-transaction deposits
Loans
Borrowings
Other assets ( such as
physical capital)
Bank capital
Total Assets = Total Liabilities + Bank capital
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Class Activity
• Rank the following bank assets from most to least
liquid:
a) Commercial Loans
b) Securities
c) Reserves
d) Physical Capital.
• They rank from most to least liquid is (c), (b), (a),
(d).
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• Which of the following statements are
TRUE?
A) A bank's assets are its sources of funds.
B) A bank's liabilities are its uses of funds.
C) A bank's balance sheet shows that total
assets equal total liabilities plus equity capital.
D) A bank's balance sheet indicates whether or
not the bank is profitable.
• Answer: C
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• Which of the following statements is
FALSE?
A) A bank's assets are its uses of funds.
B) A bank issues liabilities to acquire funds.
C) The bank's assets provide the bank with
income.
D) Bank capital is recorded as an asset on the
bank balance sheet.
Answer: D
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• Which of the following are reported as
liabilities on a bank's balance sheet?
A) reserves
B) checkable deposits
C) consumer loans
D) deposits with other banks
Answer: B
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• Which of the following are reported as
liabilities on a bank's balance sheet?
A) discount loans
B) reserves
C) Governmental Treasury securities
D) real estate loans
Answer: A
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• Which of the following statements is
FALSE?
A) Checkable deposits are usually the lowest
cost source of bank funds.
B) Checkable deposits are the primary source of
bank funds.
C) Checkable deposits are payable on demand.
D) Checkable deposits include NOW accounts.
Answer: B
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• All of the following are non-transaction
deposits EXCEPT
A) savings accounts.
B) small-denomination time deposits.
C) checkable deposits.
D) certificates of deposit.
Answer: C
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END OF LECTURE ☺
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