Chapter 9
Banking and
the Management
of Financial
Institutions
Preview Chapter 9
• Banking plays a major role in moving
funds to borrowers with investment
opportunities. This allows the economy
to run smoothly.
• In the US banks supply more than $6
trillion in credit annually.
• Banks provide loans to businesses, help
finance college, purchase a new car or
home and provide us with such services
as checking and savings accounts.
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9-2
Preview Chapter 9
• In this chapter we examine how banking
is done to earn the highest profits
possible; how and why banks make
loans, how they get funds, manage their
assets and liabilities (debts) and how
they earn income.
• The focus is on commercial banking
because this is the most important
financial intermediary activity.
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Bank Balance Sheet
• Total assets = total liabilities+capital
• A bank’s balance sheet is a list of its
sources of bank funds (liabilities) and
uses to which the funds are put (assets)
• Banks get funds by borrowing and
issuing liabilities such as deposits. They
then use these funds to acquire assets
such as securities and loans.
• Banks make profits by charging an
interest rate on their assets.
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Basic Banking
• Banks make profits by selling liabilities with
one set of characteristics (liquidity, risk, size
and return) and using the profits to buy assets
with a different set of characteristics. This
process is referred to as asset
transformation.
• For example, David opens a savings account
with banker Kevin and Kevin makes a loan to
Ann. This is described as “borrow short and
lends long”, because the bank makes a longterm loan and funds them by issuing shortdated deposits.
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9-6
Basic Banking
• To make our understanding of the
operation of a bank more simple we use
a tool called a T-account. A T-account is
a simplified balance sheet, with lines in
the form of a T, that lists the changes
that occur in balance sheet items starting
from some initial balance sheet position.
• Let’s look at an example:
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9-7
Basic Banking—Cash Deposit
First National Bank
Assets
Vault
Cash
+$100
First National Bank
Liabilities
Checkable
deposits
+$100
Assets
Reserves
Liabilities
+$100 Checkable
deposits
+$100
• Opening of a checking account leads to an
increase in the bank’s reserves equal to the
increase in checkable deposits
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Basic Banking—Check Deposit
When a bank receives
First National Bank
Assets
Cash items
in process
of collection
+$100
Checkable
deposits
+$100
gains an equal amount of reserves;
when it loses deposits,
it loses an equal amount of reserves
First National Bank
Assets
additional deposits, it
Liabilities
Second National Bank
Liabilities
Reserves +$100 Checkable
deposits
+$100
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Assets
Reserves
-$100
Liabilities
Checkable
deposits
-$100
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Check Deposit-Role of the FED
The First National Bank has $100 in cash items
in process as it must collect the money from the
Second National Bank. It could go directly to the
Second Bank for payment but the two banks are
different states and it is costly to do so. Instead
the First Bank deposits the check in the account
at the Fed and the Fed collects the funds from
the Second Bank. The result is the Fed transfers
$100 of reserves to the First Bank. Thus the
balance sheet looks like the T-account on the
previous slide.
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9-10
Basic Banking – Making a Profit
Now that you know how banks gain and lose
reserves, we will look at how it makes profits.
First, you must know that banks are required to
keep a certain fraction of its checkable deposits
as required reserves. The required amount is
10%.
Since reserves pay no interest, it has no income
from the $100 deposit. But servicing the deposit
is costly because the bank must keep records,
pay tellers, and other costs. The bank is taking a
loss! So, it makes a loan and it looks like this:
The bank is now making a profit.
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Basic Banking—Making a Profit
First National Bank
Assets
Required
reserves
Excess
reserves
First National Bank
Liabilities
+$100 Checkable
deposits
+$100
+$90
Assets
Required
reserves
Loans
Liabilities
+$100 Checkable
deposits
+$100
+$90
• Asset transformation-selling liabilities with one set of
characteristics and using the proceeds to buy assets
with a different set of characteristics
• The bank borrows short and lends long
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Bank Management
• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
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Liquidity Management:
Ample Excess Reserves
Assets
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
Capital
$10M
Securities
$100M
$10M
Assets
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank
Capital
$10M
$10M
Securities
• If a bank has ample excess reserves, a
deposit outflow does not necessitate changes
in other parts of its balance sheet
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Liquidity Management:
Shortfall in Reserves
Assets
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
Capital
$10M
Securities
$100M
$10M
Assets
Reserves
Loans
Securities
Liabilities
$0 Deposits
$90M Bank
Capital
$10M
$90M
$10M
• Reserves are a legal requirement and the
shortfall must be eliminated
• Excess reserves are insurance against the
costs associated with deposit outflows
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Liquidity Management: Borrowing
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrowing from
other banks or
corporations
Securities
$10M Bank Capital
$90M
$9M
$10M
• Cost incurred is the interest rate paid on the
borrowed funds. First of 4 ways to meet its
10% reserve requirement.
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Liquidity Management:
Securities Sale
Assets
Reserves
Loans
Securities
Liabilities
$9M Deposits
$90M Bank Capital
$90M
$10M
$1M
• The cost of selling securities is the brokerage
and other transaction costs. This is a second
way the bank the bank can help cover the
deposit outflow.
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Liquidity Management:
Federal Reserve
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital
$90M
$9M
$10M
• Borrowing from the Fed also incurs interest
payments based on the discount rate. This is a
third way the bank can cover deposit outflow.
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Liquidity Management: Reduce Loans
Assets
Reserves
Liabilities
$9M Deposits
Loans
$81M Bank Capital
Securities
$10M
$90M
$10M
• Reduction of loans is the most costly way of
acquiring reserves but is the fourth way a bank can
meet its deposit outflow. Certainly the last option.
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a
substantial discount
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Summary of Liquidity
Management & Role of Reserves
• The previous discussion explains why
banks hold excess reserves even though
loans and securities earn a higher return.
• When a deposit outflow occurs holding
excess reserves allows the bank to
escape the costs of: 1. borrowing from
banks; 2. selling securities; 3. borrowing
from the Fed; 4. calling in or selling
loans.
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9-20
Summary of Liquidity
Management & Role of Reserves
• Excess reserves are insurance against the
costs associated with deposit outflows.
The higher the costs associated with
deposit outflows, the more excess reserves
the bank will want to hold.
• Just as you and I want to pay for insurance to
protect against losses to say a car or house,
so the bank is wiling to pay the cost of holding
excess reserves (opportunity cost), to insure
against losses due to deposit outflows.
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Asset Management: Three Goals
Now we know why a bank has need for
liquidity, we look at the strategy the bank
has for managing its assets.
• Seek the highest possible returns on
loans and securities
• Reduce risk
• Have adequate liquidity
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Asset Management: Four Tools
• Find borrowers who will pay high
interest rates and have low possibility
of defaulting. Reduce adverse selection and
moral hazard problems.
• Purchase securities with high returns and low
risk
• Lower risk by diversifying
• Balance need for liquidity against increased
returns from less liquid assets, such as holding
securities with a lower return.
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Liability Management
• Recent phenomenon due to rise of money
center banks (large banks in key financial
markets, like NY and Chicago) and the federal
funds market.
• Expansion of overnight loan markets and new
financial instruments (such as negotiable CDs)
• Checkable deposits have decreased in
importance as source of bank funds from 61%
of bank liabilities in 1960 to 7% in 2005.
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Credit Risk: Overcoming Adverse
Selection and Moral Hazard
• Screening and information collection
• Specialization in lending
• Monitoring and enforcement of
restrictive covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing
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9-25
Chapter 9 Summary
1. The balance sheet of commercial banks are a
list of sources and uses of bank funds. The
banks liabilities are its sources of funds such
as checkable deposits. The banks assets are
it uses of funds such as reserves, loans &
securities.
2. Banks make profits through asset
transformation. They borrow short (accept
deposits) and lend long (make loans). As a
bank takes in and pays out deposits, it gains
and loses reserves.
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9-26
Chapter 9 Summary
3. Banks will hold more liquid assets that earn
lower returns to provide insurance against
deposit outflow. Banks manage their assets to
maximize profit y seeking the highest return
possible while at the same time lowering risk.
Large money center banks handle liability
management by seeking out sources of funds by
issuing CD’s or actively borrowing from other
banks and corporations. Banks manage the
amount of capital they hold to prevent bank
failure, yet they always want to try and maximize
returns to equity holders (shareholders).
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Chapter 9 Summary
4. Adverse
selection and moral hazard
explain the need for many credit risk
management principles involving loan
activities: screening and monitoring,
long-term customer relationships,
restrictive covenants and collateral.
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9-28
Chapter 9 Study questions
1. (2.) Rank the following bank assets
from most to least liquid: a. Commercial
loans; b. Securities; c. Reserves; d.
Physical capital.
2. (3.) Using the T-accounts of the First
Bank & Second Bank show what
happens when Jane writes a $50 check
on her account at the First Bank to pay
her friend Joe who deposits the check
in his account at the second Bank.
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Chapter 9 Study questions
3. (4.) What happens to reserves at the First Bank if John
withdraws $1000 of cash and Tracy deposits $500 of
cash? Use T accounts to explain your answer.
4. (5.) The bank you own has the below balance sheet:
If the bank suffers a deposit outflow of $50 million with a
required reserve ratio of on deposits of 10%, what
actions must you take to keep your bank from failing?
ASSETS
LIABILITIES
Reserves
$ 75 million
Deposits
$500 million
Loans
$525 million
Bank Capital
$100 million
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Chapter 9 Study questions
5. (7.) Why has the development of overnight loan
markets made it more likely that banks will hold fewer
excess reserves?
6. If a deposit outflow of $50 million occurs, which
balance sheet would a bank rather have at first, the
balance sheet in question 4 or the following balance
sheet? Why?
ASSETS
LIABILITIES
Reserves
$100 million Deposits
$500 million
Loans
$525 million
$100 million
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Bank Capital
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Chapter 9 Study questions
7. (8.) If the bank you own has no excess
reserves and a good customer comes in
asking for a loan should you turn the
customer down, telling him that you have
no excess reserves to loan out? Why or
why not? What options are available for
you to give out the funds your customer
needs?
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