Lesson 9: The Business of Banking |
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Upon completion of this lesson, you should be able to do the following:
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IntroductionThis 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 CapitalFirst, 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: |
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Total Assets = Total Liabilities + capital |
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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.
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.
Determining Bank Profits through T-AccountsA 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: |
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Your Bank
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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: |
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Your Bank
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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: |
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Your Bank
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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.
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. |
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Your Bank
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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. |
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Your Bank
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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:
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Your Bank
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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. |
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Your Bank
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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. |
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Your Bank
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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. |
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Your Bank
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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.
Interest Rate RiskWith 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: |
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Your Bank
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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:
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. |
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