Unit 4 Written Assignment

BUS 2203: Principles of Finance 1

University of the People

Galin Todorov
In this paper, I will explore the key characteristics of a bank balance sheet, using the example

provided by the assignment rubric.

A bank balance sheet diverges from that of a typical company in a few ways: First, a

bank’s asset base is significantly different. Though banks do of course maintain physical assets

such as property and equipment like a regular company, we are more likely to see loans and

investments on a bank’s balance sheet as opposed to the typical accounts receivable and payable.

As the textbook describes, loans typically represent a bank’s “bread-and-butter” asset, from

which they derive the majority of their income (Wright & Quadrini, 2009).

Second, the scope of a bank’s balance sheet is far more limited than that of a regular

company. It is deliberately simplified to reflect the dynamic and constantly changing nature of a

bank’s assets and liabilities. As the textbook notes, the “easiest way to analyze that dynamism is

via so-called T-accounts, simplified balance sheets that list only changes in liabilities and assets”

(Wright & Quadrini, 2009, p. 190).

Finally, the aforementioned dynamism that is characteristic of a bank’s business is

reflected in the fact that the balances on its financial statements are less precise than they would

be for a typical company. Instead, the balances provided are average amounts, which are deemed

to “provide a better analytical framework to help understand the bank's financial performance”

(Wagner, 2021).

In the sample balance sheet provided, the bulk of the liabilities (61 percent) are customer

deposits. These are considered liabilities because a customer can choose to withdraw their funds

at any given moment and the bank is obligated to return the funds. Failure to manage liquidity

risk, which at its most basic level reflects a financial institution’s ability to make good on its

deposit obligations, can be catastrophic for a bank. One example that comes to mind took place
during my early adulthood, while living in the United Kingdom: Upon learning that Northern

Rock, a retail bank with a relatively significant national presence, was potentially facing liquidity

problems, panicked customers rushed to withdraw their savings. In just two days, customers

extracted some £2 billion from their accounts, forcing the government to intervene and guarantee

deposits. (BBC News, 2007). The story did not end well for Northern Rock, which is now

defunct.

When reviewing the assets featured on the balance sheet in question, it is immediately

obvious that loans comprise the overwhelming majority at 64 percent. This is entirely to be

expected, given that “a bank is in the business of lending money and its primary money use is to

issue loans to businesses and consumers.” (Way, n.d.).

Indeed, bank managers tend to prefer loans over securities because they typically carry

higher interest rates and thus generate greater profit for the bank. Bankers are less keen to place

their assets into fixed-income securities, “because the yield isn't that great. However, investment-

grade securities are liquid, and they have higher yields than cash, so it's always prudent for a

bank to keep securities on hand in case they need to free up some liquidity.” (Lee, 2018). Loans

also offer banks the opportunity to forge long-term and lucrative relationships with businesses by

providing loan commitments, i.e., “promises to lend $x at y interest (or y plus some market rate)

for z years” (Wright & Quadrini, 2009, p.202).

With that said, of course, the extension of loans to borrowers introduces credit risk, i.e.,

“the chance that a borrower will default on a loan by not fully meeting stipulated payments on

time” (Wright & Quadrini, 2009, p.204). Banks manage for credit risk and thereby limit the

likelihood of extensive defaults in a number of ways. These methods include screening of

applicants to determine their creditworthiness, monitoring existing customers’ financial habits

introducing restrictive terms in the loan contract. In addition, banks manage credit risk by

“trading off between the costs and benefits of specialization and portfolio diversification”

(Wright & Quadrini, 2009, p. 204).

The bank in question’s cash reserves are just 4 percent—presumably because it is a

smaller, non-commercial institution that is not subject to the Federal Reserve’s cash reserve

requirement of 10 percent. It’s worth noting, however, that the latter has temporarily been

waived amid the COVID-19 crisis in an effort to stimulate lending (Amadeo, 2020). Besides,

most banks prefer to keep cash reserves to a minimum so they can employ those funds more

profitably elsewhere—there is significant opportunity cost in holding large amounts of cash. By

putting funds to work in loans and investments, banks are able to instead generate greater profit

than they would on cash.

References:

Amadeo, K. (2020, October 27). Why the Fed Removed the Reserve Requirement. The Balance.

https://www.thebalance.com/reserve-requirement-3305883

BBC News. (2007, September 17). BBC NEWS | Business | Northern Rock withdrawals at £2bn.

http://news.bbc.co.uk/2/hi/business/6997264.stm

Lee, E. (2018, October 2). Understanding a Bank’s Balance Sheet. The Motley Fool.

https://www.fool.com/investing/general/2007/01/05/understanding-a-banks-balance-

sheet.aspx

Way, J. (n.d.). What Are the Major Assets & Claims on a Commercial Bank’s Balance Sheet?

Sapling. https://www.sapling.com/8580386/major-commercial-banks-balance-sheet
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under

Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0

license. Available from: https://www.saylor.org/site/textbooks/Money%20and%20Banking.pdf