The Banking Firm and the Management of Financial Institutions
The Bank Balance Sheet
Balance Sheet of all Commercial Banks (percent of total 1999)
Assets
Liabilities + capital
Reserves
(1%)
Checkable deposits
Cash items in the process
of collection + deposits at
other banks
Securities
U.S. government
State and Local
(4%)
(14%)
(8%)
Nontransaction deposits
(37%)
 Small denomination time
deposits (<100,000) + savings
deposits
 Large denomination time
deposits
(15%)
Borrowings
Loans
Commercial and Industrial
Real Estate
Consumer
Interbank
Other
Other assets (bulldings,
Computers, etc(
(18%)
(26%)
(9%)
(4%)
(9%)
(11%)
Bank Capital
(29%)
(8%)
(7%)
Liabilities -- what the bank owes other people
Checkable deposits

Non interest bearing checking accounts (demand deposits), NOW
accounts, money market deposits accounts

Essentially M1
Nontransaction deposits

Deposits that don’t allow check writing privileges (usually have higher
interest rates).

Savings accounts (no maturity date). Can usually withdraw when you
present yourself to bank. Could require that you wait for a period of time
before withdrawal.

Time deposits < 100,000 (CD’s) have a maturity date and penalty for early
withdrawal. Less liquid than savings accounts but pay higher interest.
(components of M2)

Time deposits >=100,000 (CD’s) are negotiable – sold in secondary
market. (Components of M3)
Borrowings

From FED (called discount loans)

From other banks (overnight borrowing of other banks reserves. This is
called the federal funds market. It has nothing to do with the government.
The purpose is to ensure that a bank has adequate reserves to meet FED
requirements)

From parent company (called a holding company).

Loans from companies (repos –repurchase agreements)

Borrowings of Eurodollars (deposits denominated in U.S. dollars residing
in foreign banks or foreign branches of U.S. banks).
Bank Capital

This is owed to the banks owners (stockholders). This is what they stand
to lose if the bank fails. The hope is they will hire good managers so they
will not lose this money.
ASSETS -- this is what the banks use to earn revenue.
Reserves – a bank must hold reserves to be able to pay depositors. Reserves
consist of currency that the bank holds (vault cash) plus deposits that the bank
has with the FED. Banks earn nothing on reserves.
 Required reserves – this is the amount that the FED forces the banks to
have as reserves. This will be some percentage of deposits. Used by the
FED to prevent bank panics and control the money supply.
 Excess reserves = amount of reserves a banks has in addition to required
reserves.
o total Reserves = required reserves + excess reserves
The existence of excess reserves permits the expansion of the money
supply

Cash items in the process of collection

Deposits at other banks
o Correspondent banking – small banks have deposits at large banks as
a means of paying for certain services such as check collection,
foreign exchange transactions and the purchase of securities.



Securities – Treasury bonds, treasury bills, U.S. government agency
securities, State and Local government securities. These area very
liquid assets and can be bought or sold in s secondary market. Often
called secondary reserves because they are so liquid. These are also
important in the control of the money supply.
Loans -- chief source of bank earnings. Not as liquid as securities but
more profitable (as long as they are good loans).
o Commercial and industrial – to companies
o Consumer loans – for cars, home improvement
o Real Estate loans -- mortgages
o Loans to other banks via federal funds/
Other assets – the bank buildings, computers and other physical capital.
Note that banks are not allowed to own other companies or farms or
real estate.
Bank Operations
Create the bank – some close friends scrape together $1000 to create a bank.
The $1000 is bank capital is a liability but the bank can use it as an asset
to make money. Initially it will be a part of bank reserves until they buy a
security or make a loan.
Assets
Reserves
$1000
Liabilites + capital
Capital
$1000
Bank gets depositors – they deposit $10000 in a checking accoung
Assets
Reserves
Liabilites + capital
$11000
DdDemand deposits
$10,000
Capital
Total
$11000 Total
$1000
$11000
The bank is still not making money. To do so it makes some loans and buys
some government securities. Let us suppose that the FED requires the bank to
keep 10% of demand deposits in the form of reserves (Reserve Ratio = 0.1).
Assets
Reserves
Required
Excess
Loans
Bonds
Total
Liabilites + capital
$2000
DdDemand deposits
$10,000
$1000
$1000
Capital
$1000
$4000
$5000
$11000
Total
$11000
Because assets = liabilities + capital this bank must have $11000 in assets. If
the bank has purchased $5000 in bonds and make loans totaling $4000 then that
accounts for $9000 of the assets. The remainder, $2000, is in the form of
reserves. The FED requires the bank to have 0.1*10000 in the form of required
reserves. The amount in excess of requires reserves is excess reserve = $1000.
Someone writes a check for $1000 on their deposit
Assets
Reserves
Required
Excess
Loans
Bonds
Liabilites + capital
$1000DdDemand deposits
$900
$100
Capital
$9,000
$1000
$4000
$5000
Total
$10000
Total
$10000
Why Have Excess Reserves
Banks earn no direct profits by holding excess reserves, so why do it? Consider
a bank with zero excess reserves.
Assets
Reserves
Required
Excess
Loans
Bonds
Liabilites + capital
$1000DdDemand deposits
$1000
$
0
Capital
$10,000
$1000
$5000
$5000
Total
$11000
Total
$110000
Now suppose someone cashes a check
Assets
Reserves
Required
Excess
Loans
Bonds
Total
$
$900
-$900
Liabilites + capital
0DdDemand deposits
Capital
$9,000
$1000
$5000
$5000
$10000
Total
$10000
However banks must have at least the required amount of reserves on hand. So
if a bank has zero excess reserves it cannot meet the reserve requirement of the
FED if anyone cashes a check on the bank or withdraws a deposit.
What might the bank do to get adequate required reserves in this case?
1. Borrow from other banks in the federal funds market (must pay
interest)
2. Sell some securities (may take a capital loss).
3. Call in loans (not renewing short term loans – makes customers mad.)
o Can also sell loans to other banks likely at a loss.
4. Borrowing from the FED
o Pay interest to FED
o FED discourages regular borrowing. This should only be used
for extraordinary circumstances.
All four of these options are costly. For that reason banks find it useful to
maintain a level of excess reserves greater than zero. The trade off is that the
bank earns no profits on excess reserves.
Asset Management
How do banks allocate assets between securities, reserves, and loans? Loans
tend to be the most profitable on average. The also tend to be riskier than
securities. Reserves are risk free but earn nothing. Banks must balance risk and
return.
1. Try to find borrowers who will pay high interest rates and are unlikely to
default. Banks are very conservative and the default rate is only about
1%. Banks often specialize in making loans to specific borrowers such as
farmers, energy companies and real estate developers. This can be risky
if the industry slumps.
2. Find government securities that pay high returns and have little risk.
There is very little default risk with government securities. There is still
interest rate risk with holding long term bonds.
3. Must manage assets to meet reserve requirements.
Liability Management
Not a problem before the 60’s. Banks had few different types of liabilities. Sixty
percent of the liabilities were checkable deposits that didn’t pay interest. So
there was little competition for depositors (well they did give away toaster ovens).
Also there was little bank borrowing from one another to meet reserve needs.
Banks began to seek depositors by creating new kinds of liabilities (NOW
accounts, negotiable CD’s, federal funds market). If banks have more liabilities
they also have more assets.
Bank Capital
Bank capital is what the bank owes to the stockholders. Stockholders would like
to be owed nothing they would prefer to have the money now. Consider the
following situation.
Assets
Reserves
Required
Excess
Loans
Bonds
Liabilites + capital
$2000DdDemand deposits
$1000
$1000
Capital
$10,000
$1000
$4000
$5000
Total
$11000
Total
$11000
Now the banks sells a bond it has on the books for $1000 and receives $2000 for
it.
Assets
Reserves
Required
Excess
Loans
Bonds
Total
Liabilites + capital
$4000DdDemand deposits
$1000
$3000
Capital
$10,000
$2000
$4000
$4000
$12000
Total
$12000
Assets increase by $1000 which goes into reserves and liabilities also increase
by $1000 which goes into bank capital. The bank could give the $1000 to the
stockholders in the form of dividends. In fact they could give the stockholders
$2000 in dividends. Capital belongs to the stockholders. Why not give them
what they own?
We want the bank owners to hire responsible managers who will not make overly
risky loans or other bad investments. If the owners stand to lose nothing they
may not care about what the manager does. If they stand to lose funds they are
apt to be far more interested in hiring responsible managers.
For this reason banking regulators require a certain amount of the banks
liabilities in the form of capital.
The 1990’s Credit Crunch
In the late 1980’s banks lost a lot of money due to failed real estate loans. The
bank had to write off bad loans. This reduction in assets must be offset by a
reduction on the liabilities side (a reduction in capital). At this time regulators
were also raising capital requirements. Banks had to raise new capital or cut
back on lending. This occurred during a recession and probably made the
recession worse.
Managing Credit Risk
Adverse Selection and Moral Hazard
Adverse Selection: Bad credit risks are likely to apply to numerous banks for
loans. If they get turned down at one place they will try again. There is some
probability that they will slip through somewhere and get a loan.
Moral Hazard: once a borrower has got a loan they may be tempted to invest in
high risk projects. This will pay them high returns but make it more likely that
they will not be able to repay the loan.
Banks will be more profitable if they can reduce these problems.
Banks reduce the problems associated with adverse selection by
Banks reduce adverse selection by


Screening: Prospective borrowers must provide information about
their credit history and current financial situation (income, debt, assets)
and other personal information (age, employment history, number of
children). This and other information (credit bureau reports) are used
to determine if the borrower gets a loan.
Specializing in Lending Banks often make loans to specific
borrowers (farm, energy companies, real estate developers). By
specializing banks become familiar with the workings of the industry
and of the individuals operating in the industry. This knowledge should
be useful in determining who to lend to.
There is a problem. What happens when the industry goes sour and
this is the only thing you specialize in. The bank does not diversify.
Moral Hazard Banks monitor activities of borrowers. They may
require provisions in the loan contract that restrict the activities of the
borrower.
Long Term Customer Relationships: Another way of gaining information
about the customer. The bank has knowledge about customers that it has had a
history of banking activity. This also makes it easier for customers to get loans.
Banks engage in activities to establish long term relationships with customers.
 Loan Commitments: The bank makes a commitment to make loans to
commercial customers. The customer has access to funds—the bank
builds a relationship.
 Collateral and Compensating Balances: Collateral is what the borrower
stands to lose if a loan is not repaid. The house is usually used a
collateral for a home mortgage loan. Customers are often required to
maintain deposits in the bank where a loan is made (Compensating
balance). This also gives the bank a means of monitoring the behavior of
the borrower (moral hazard) –the bank can track check payment practices.
Managing Interest Rate Risk
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First National Bank
Assets
Rate sensitive assets
mil
Variable rate loans
Short term securities
Federal funds
Fixed rate assets
mil
Reserves
Long term loans
Long term securities
Liabilities
$20 Rate—sensitive liabilities
$50
mil
Variable rate CD’s
Money market deposit accounts
$80
Fixed—rate liabilities
mil
Checkable deposits
Savings deposits
Long term CD’s
Bank Capital
$50
This bank has a mismatch between assets and liabilities. The bank may have to
compete by offering higher interest rates to holders of rate sensitive deposits (50
mil). But the bank only has $20 million in rate sensitive assets. If the bank has
to offer the holders of rate sensitive deposits higher interest rates to keep them
as customers it will have difficulty in offsetting this using its rate sensitive assets
because they only amount to $20 mil. If interest rates rise this bank will lose
profits. Of course the bank will increase profits if interest rates fall.
If the bank manager believes that interest rates will fall he may decide to do
nothing. If he believes that they will rise he may decide to sell some long term
securities or loans. Of course if a lot of other people feel the same way the bank
may take a loss on the sale.
Off Balance Sheet Activities
Loan Sales
The banks sells a loan to some other party. The loan disappears from the
balance sheet. If the bank earns a profit then it may pay the bank owners
a dividend. These may be particularly profitable if interest rates fall.
Generation of Fee Income
Income the bank generates by charging fees for services provided to customers.
 Assisting customers with foreign exchange trades
 Guaranteeing debt securities such as bankers acceptances.
 Providing backup lines of credit
 Correspondence banking
Trading Activities and Risk Management Techniques
Banks can try to manage interest rate risk by using exotic trading activities (such
as financial futures, options trading, and debt swaps). These can be very
profitable but can also be risky. The potential for great profits contains its own
risk. A bank agent who wins the trading activities game can earn a very high
salary. This can lead to agents who will gamble excessively. If the agent loses,
however, the bank (the principle) must cover the loses. This is called the
principle—agent problem. The principle—agent problem has lead to the failure
of very large banks (Barings for example).
Banks try to reduce the principle—agent problem by setting internal controls.
Financial Innovation
Financial innovation gives banks new ways to earn profits. Some of these
innovations affect bank liabilities. NOW accounts (essentially checking accounts
that pay interest) provided banks a means of competing for customers. If the
bank is successful in attracting new deposits it will have more assets to use to
make profits. Other innovations that have been used to attract depositors are
such things a repurchase agreements and negotiable CD’s. Federal funds
borrowing is also an example of an innovation that affects bank liabilities. Other
innovations affect how banks manage assets.

Adjustable—rate mortgages Banks can lose a great deal on fixed rate
mortgages if the interest rates rise substantially. Mortgages are usually
long term assets while banks often have mostly short term liabilities.
Suppose a bank had issued a 30 year mortgage for 7% and shortly after
market interest rates went to 9%. Banks will build in a factor to protect
against this by making the mortgage rate higher. But this is apt to
discourage borrowers, particularly first time home buyers. To avoid this
problem banks created adjustable rate mortgages. If market interest rates
go up so does the interest rate on the mortgage.

Bank Credit and Debit cards Bank credit cards make it easy for
customers to make small loans without having to apply and fill out
paperwork. This lowers the cost to both the customer and the bank. The
debit card also reduces the paperwork cost to the bank.

Electronic Banking Facilities ATMs, smart cards, electronic payments
all lower processing costs to banks and customers
Avoidance of Existing Regulation


Reserve Requirements Banks earn no interest on reserves. The FED
requires a certain amount of reserves so this regulation costs banks
revenue. This led to federal funds markets. Also banks attracted
Eurodollars which were not subject to reserve requirements. Commercial
paper issued by a banks holding company is also exempt from these
regulations.
Restrictions on Interest Paid on Deposits. Regulation Q set the
maximum interest rate banks could earn on time deposits. If market
interest rates exceeded Regulation Q limits customers would withdraw
funds from the bank.
o NOW accounts Banks are also prohibited from giving interest on
checking accounts (so the NOW account was created)
o Sweep accounts. Banks can’t pay interest on corporate checking
accounts. The funds in the corporate checking account are “lent” to
the bank overnight The bank sells the corporation Treasury bills
with the understanding the bank will buy them back at a higher
price the next day. These are called sweep accounts or overnight
repos (repurchase agreements).
Questions
1. If the Fed make an open market purchase what will happen to
a. Reserves in the banking system
b. Liabilities of the Fed
c. Assets of the Fed
2. What will happen to M1 if someone puts $100 in cash into a checking
account (assume that the bank does not increase lending)?
3. What will happen to M1 if banks decide to increase lending?
4. What will happen to M1 if banks decide to call in loans?
5. What will happen to M1 if banks decide to increase excess reserves?
6. What will happen to M1 if someone transfers money from a savings
account to a checking account?
7. What will happen to reserves if someone puts $100 in cash into a
checking account?
8. What will happen to the monetary base if someone puts $100 in cash
into a checking account (assume the bank does not increase
lending)?
9. Which of the following are depository institutions?
A) Commercial banks
B) Savings and loan associations
C) Mutual savings banks
D) Credit Unions
E) The Federal Reserve
10. The monetary base consists of
a. The monetary liabilities of the Fed plus the monetary liabilities
of the Treasury
b. vault cash, deposits at the Fed, and currency in circulation
11. What is a discount loan and why are they made?
12. What will happen to the money supply if a discount loan is made?
13. What will happen to the monetary base if a discount loan is made?
14. How can the Fed increase reserves in the banking system?