Republic of the Philippines

CAMARINES NORTE STATE COLLEGE

F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

HANDOUTS #2 – PART 2
BANKING AND FINANCIAL INSTITUTION

Name of Faculty : RAYNIEL D. ZABALA

Schedule for Instruction : TTH, 8-9:30AM, MW, 11-12:30NN, 2:3:30PM
Contact Number/Email Add. : 09988590853/[email protected]
Lesson/Topic : The Bank Balance Sheet
Objectives : At the end of this lesson, students should be able to:
1. Summarize the Features of Bank Balance Sheet
2. Apply Bank’s Assets and Liabilities on a T-account
3. Identify ways in which banks can manage their assets and
liabilities to maximize profit
4. List the ways in which bank deals with credit risk

TOPIC
DISCUSSION:

BASIC BANKING

Before proceeding to a more detailed study of how a bank manages its assets and liabilities in order to
make the highest profit, you should understand the basic operation of a bank.
In general terms, banks make profits by selling liabilities with one set of characteristics (a particular
combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a different set of
characteristics. This process is often referred to as asset transformation. For example, a savings deposit held
by one person can provide the funds that enable the bank to make a mortgage loan to another person. The
bank has, in effect, transformed the savings deposit (an asset held by the depositor) into a mortgage loan (an
asset held by the bank). Another way this process of asset transformation is described is to say that the bank
“borrows short and lends long” because it makes long-term loans and funds them by issuing short-dated
deposits.
The process of transforming assets and providing a set of services (check clearing, record keeping,
credit analysis, and so forth) is like any other production process in a firm. If the bank produces desirable
services at low cost and earns substantial income on its assets, it earns profits; if not, the bank suffers losses.
To make our analysis of the operation of a bank more concrete, 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 only the changes that occur in
balance sheet items starting from some initial balance sheet position. Let’s say that Jane Brown has heard that
the First National Bank provides excellent service, so she opens a checking account with a $100 bill. She now
has a $100 checkable deposit at the bank, which shows up as a $100 liability on the bank’s balance sheet. The
bank now puts her $100 bill into its vault so that the bank’s assets rise by the $100 increase in vault cash. The
T-account for the bank looks like this:

Since
vault cash is
also part of
the bank’s reserves, we can rewrite the T-account as follows:

Note that Jane Brown’s opening of a checking account leads to an increase in the bank’s reserves
equal to the increase in checkable deposits.
If Jane had opened her account with a $100 check written on an account at another bank, say, the
Second National Bank, we would get the same result. The initial effect on the T-account of the First National
Bank is as follows:
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CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

Checkable deposits increase by $100 as before, but now the First National Bank is owed $100 by the
Second National Bank. This asset for the First National Bank is entered in the T-account as $100 of cash items
in process of collection because the First National Bank will now try to collect the funds that it is owed. It could
go directly to the Second National Bank and ask for payment of the funds, but if the two banks are in separate
states, that would be a time-consuming and costly process. Instead, the First National Bank deposits the check
in its account at the Fed, and the Fed collects the funds from the Second National Bank. The result is that the
Fed transfers $100 of reserves from the Second National Bank to the First National Bank, and the final balance
sheet positions of the two banks are as follows:

The
process initiated by Jane Brown can be summarized as follows: When a check written on an account at one
bank is deposited in another, the bank receiving the deposit gains reserves equal to the amount of the check,
while the bank on which the check is written sees its reserves fall by the same amount. Therefore, when a
bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an
equal amount of reserves.
Now that you understand how banks gain and lose reserves, we can examine how a bank rearranges
its balance sheet to make a profit when it experiences a change in its deposits. Let’s return to the situation
when the First National Bank has just received the extra $100 of checkable deposits. As you know, the bank is
obliged to keep a certain fraction of its checkable deposits as required reserves. If the fraction (the required
reserve ratio) is 10%, the First National Bank’s required reserves have increased by $10, and we can rewrite
its T-account as follows:

Let’s see how well the bank is doing as a result of the additional checkable deposits. Because reserves
pay no interest, it has no income from the additional $100 of assets. But servicing the extra $100 of checkable
deposits is costly, because the bank must keep records, pay tellers, return canceled checks, pay for check
clearing, and so forth. The bank is taking a loss! The situation is even worse if the bank makes interest
payments on the deposits, as with NOW accounts. If it is to make a profit, the bank must put to productive use
all or part of the $90 of excess reserves it has available.
Let us assume that the bank chooses not to hold any excess reserves but to make loans instead. The
T-account then looks like this:

The bank is now making a profit because it holds short-term liabilities such as checkable deposits and
uses the proceeds to buy longer-term assets such as loans with higher interest rates. As mentioned earlier,
this process of asset transformation is frequently described by saying that banks are in the business of
“borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank
earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

5% interest rate and it costs another $3 per year to service the account, the cost per year of these deposits is
$8. The bank’s profit on the new deposits is then $1 per year (a 1% return on assets).

General Principles of Bank Management

Now that you have some idea of how a bank operates, let’s look at how a bank manages its assets and
liabilities in order to earn the highest possible profit. The bank manager has four primary concerns. The first is
to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows, that
is, when deposits are lost because depositors make withdrawals and demand payment. To keep enough cash
on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the
bank’s obligations to depositors. Second, the bank manager must pursue an acceptably low level of risk by
acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). The
third concern is to acquire funds at low cost (liability management). Finally, the manager must decide the
amount of capital the bank should maintain and then acquire the needed capital (capital adequacy
management).
To understand bank and other financial institution management fully, we must go beyond the general
principles of bank asset and liability management described next and look in more detail at how a financial
institution manages its assets. The two sections following this one provide an in-depth discussion of how a
financial institution manages credit risk, the risk arising because borrowers may default, and how it manages
interest-rate risk, the riskiness of earnings and returns on bank assets that results from interest-rate changes.

Liquidity Management and the Role of Reserves

Let us see how a typical bank, the First National Bank, can deal with deposit outflows that occur when
its depositors withdraw cash from checking or savings accounts or write checks that are deposited in other
banks. In the example that follows, we assume that the bank has ample excess reserves and that all deposits
have the same required reserve ratio of 10% (the bank is required to keep 10% of its time and checkable
deposits as reserves). Suppose that the First National Bank’s initial balance sheet is as follows:

The bank’s required reserves are 10% of $100 million, or $10 million. Since it holds $20 million of
reserves, the First National Bank has excess reserves of $10 million. If a deposit outflow of $10 million occurs,
the bank’s balance sheet becomes:

The bank loses $10 million of deposits and $10 million of reserves, but since its required reserves are
now 10% of only $90 million ($9 million), its reserves still exceed this amount by $1 million. In short, if a bank
has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet.
The situation is quite different when a bank holds insufficient excess reserves. Let’s assume that
instead of initially holding $10 million in excess reserves, the First National Bank makes loans of $10 million, so
that it holds no excess reserves. Its initial balance sheet would be:
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

When it suffers the $10 million deposit outflow, its balance sheet becomes:

After $10 million has been withdrawn from deposits and hence reserves, the bank has a problem: It has
a reserve requirement of 10% of $90 million, or $9 million, but it has no reserves! To eliminate this shortfall, the
bank has four basic options. One is to acquire reserves to meet a deposit outflow by borrowing them from
other banks in the federal funds market or by borrowing from corporations.1 If the First National Bank acquires
the $9 million shortfall in reserves by borrowing it from other banks or corporations, its balance sheet becomes:

The cost of this activity is the interest rate on these borrowings, such as the federal funds rate. A
second alternative is for the bank to sell some of its securities to help cover the deposit outflow. For example, it
might sell $9 million of its securities and deposit the proceeds with the Fed, resulting in the following balance
sheet:

The bank incurs some brokerage and other transaction costs when it sells these securities. The U.S.
government securities that are classified as secondary reserves are very liquid, so the transaction costs of
selling them are quite modest. However, the other securities the bank holds are less liquid, and the transaction
cost can be appreciably higher. A third way that the bank can meet a deposit outflow is to acquire reserves by
borrowing from the Fed. In our example, the First National Bank could leave its security and loan holdings the
same and borrow $9 million in discount loans from the Fed. Its balance sheet would be:

The cost associated with discount loans is the interest rate that must be paid to the Fed (called the
discount rate).
Finally, a bank can acquire the $9 million of reserves to meet the deposit outflow by reducing its loans
by this amount and depositing the $9 million it then receives with the Fed, thereby increasing its reserves by $9
million. This transaction changes the balance sheet as follows:

The First National Bank is once again in good shape because its $9 million of reserves satisfies the
reserve requirement. However, this process of reducing its loans is the bank’s costliest way of acquiring
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

reserves when there is a deposit outflow. If the First National Bank has numerous short-term loans renewed at
fairly short intervals, it can reduce its total amount of loans outstanding fairly quickly by calling in loans—that is,
by not renewing some loans when they come due. Unfortunately for the bank, this is likely to antagonize the
customers whose loans are not being renewed because they have not done anything to deserve such
treatment. Indeed, they are likely to take their business elsewhere in the future, a very costly consequence for
the bank.
A second method for reducing its loans is for the bank to sell them off to other banks. Again, this is very
costly because other banks do not personally know the customers who have taken out the loans and so may
not be willing to buy the loans at their full value (This is just the lemons adverse selection problem described in
Chapter 8.) The foregoing discussion explains why banks hold excess reserves even though loans or
securities earn a higher return. When a deposit outflow occurs, holding excess reserves allows the bank to
escape the costs of (1) borrowing from other banks or corporations, (2) selling securities, (3) borrowing from
the Fed, or (4) calling in or selling off loans. Excess reserves are insurance against the costs associated
with deposit outflows. The higher the costs associated with deposit outflows, the more excess
reserves banks will want to hold.
Just as you and I would be willing to pay an insurance company to insure us against a casualty loss
such as the theft of a car, a bank is willing to pay the cost of holding excess reserves (the opportunity cost,
which is the earnings forgone by not holding income-earning assets such as loans or securities) in order to
insure against losses due to deposit outflows. Because excess reserves, like insurance, have a cost, banks
also take other steps to protect themselves; for example, they might shift their holdings of assets to more liquid
securities (secondary reserves).

Asset Management
Now that you understand why a bank has a need for liquidity, we can examine the basic strategy a
bank pursues in managing its assets. To maximize its profits, a bank must simultaneously seek the highest
returns possible on loans and securities, reduce risk, and make adequate provisions for liquidity by holding
liquid assets. Banks try to accomplish these three goals in four basic ways.
First, banks try to find borrowers who will pay high interest rates and are unlikely to default on their
loans. They seek out loan business by advertising their borrowing rates and by approaching corporations
directly to solicit loans. It is up to the bank’s loan officer to decide if potential borrowers are good credit risks
who will make interest and principal payments on time (i.e., engage in screening to reduce the adverse
selection problem). Typically, banks are conservative in their loan policies; the default rate is usually less than
1%. It is important, however, that banks not be so conservative that they miss out on attractive lending
opportunities that earn high interest rates.
Second, banks try to purchase securities with high returns and low risk. Third, in managing their assets,
banks must attempt to lower risk by diversifying. They accomplish this by purchasing many different types of
assets (short- and long-term, U.S. Treasury, and municipal bonds) and approving many types of loans to a
number of customers. Banks that have not sufficiently sought the benefits of diversification often come to
regret it later. For example, banks that had overspecialized in making loans to energy companies, real estate
developers, or farmers suffered huge losses in the 1980s with the slump in energy, property, and farm prices.
Indeed, many of these banks went broke because they had “put too many eggs in one basket.”
Finally, the bank must manage the liquidity of its assets so that it can satisfy its reserve requirements
without bearing huge costs. This means that it will hold liquid securities even if they earn a somewhat lower
return than other assets. The bank must decide, for example, how much in excess reserves must be held to
avoid costs from a deposit outflow. In addition, it will want to hold U.S. government securities as secondary
reserves so that even if a deposit outflow forces some costs on the bank, these will not be terribly high. Again,
it is not wise for a bank to be too conservative. If it avoids all costs associated with deposit outflows by holding
only excess reserves, losses are suffered because reserves earn no interest, while the bank’s liabilities are
costly to maintain. The bank must balance its desire for liquidity against the increased earnings that can be
obtained from less liquid assets such as loans.

Liability Management
Before the 1960s, liability management was a staid affair: For the most part, banks took their liabilities
as fixed and spent their time trying to achieve an optimal mix of assets. There were two main reasons for the
emphasis on asset management. First, over 60% of the sources of bank funds were obtained through
checkable (demand) deposits that by law could not pay any interest. Thus banks could not actively compete
with one another for these deposits by paying interest on them, and so their amount was effectively a given for
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

an individual bank. Second, because the markets for making overnight loans between banks were not well
developed, banks rarely borrowed from other banks to meet their reserve needs.
Starting in the 1960s, however, large banks (called money center banks) in key financial centers, such
as New York, Chicago, and San Francisco, began to explore ways in which the liabilities on their balance
sheets could provide them with reserves and liquidity. This led to an expansion of overnight loan markets, such
as the federal funds market, and the development of new financial instruments such as negotiable CDs (first
developed in 1961), which enabled money center banks to acquire funds quickly.
This new flexibility in liability management meant that banks could take a different approach to bank
management. They no longer needed to depend on checkable deposits as the primary source of bank funds
and as a result no longer treated their sources of funds (liabilities) as given. Instead, they aggressively set
target goals for their asset growth and tried to acquire funds (by issuing liabilities) as they were needed.
For example, today, when a money center bank finds an attractive loan opportunity, it can acquire
funds by selling a negotiable CD. Or, if it has a reserve shortfall, funds can be borrowed from another bank in
the federal funds market without incurring high transaction costs. The federal funds market can also be used to
finance loans. Because of the increased importance of liability management, most banks now manage both
sides of the balance sheet together in a so-called asset–liability management (ALM) committee. The emphasis
on liability management explains some of the important changes over the past three decades in the
composition of banks’ balance sheets. While negotiable CDs and bank borrowings have greatly increased in
importance as a source of bank funds in recent years (rising from 2% of bank liabilities in 1960 to 42% by the
end of 2002), checkable deposits have decreased in importance (from 61% of bank liabilities in 1960 to 9% in
2002). Newfound flexibility in liability management and the search for higher profits have also stimulated banks
to increase the proportion of their assets held in loans, which earn higher income (from 46% of bank assets in
1960 to 64% in 2002).

Capital Adequacy Management

Banks have to make decisions about the amount of capital they need to hold for three reasons. First,
bank capital helps prevents bank failure, a situation in which the bank cannot satisfy its obligations to pay its
depositors and other creditors and so goes out of business. Second, the amount of capital affects returns for
the owners (equity holders) of the bank. And third, a minimum amount of bank capital (bank capital
requirements) is required by regulatory authorities.
How Bank Capital Helps Prevent Bank Failure. Let’s consider two banks with identical balance sheets,
except that the High Capital Bank has a ratio of capital to assets of 10% while the Low Capital Bank has a ratio
of 4%.

Suppose that both banks get caught up in the euphoria of the telecom market, only to find that $5
million of their telecom loans became worthless later. When these bad loans are written off (valued at zero),
the total value of assets declines by $5 million, and so bank capital, which equals total assets minus liabilities,
also declines by $5 million. The balance sheets of the two banks now look like this:

The High Capital Bank takes the $5 million loss in stride because its initial cushion of $10 million in
capital means that it still has a positive net worth (bank capital) of $5 million after the loss. The Low Capital
Bank, however, is in big trouble. Now the value of its assets has fallen below its liabilities, and its net worth is
now $1 million. Because the bank has a negative net worth, it is insolvent: It does not have sufficient assets to
pay off all holders of its liabilities (creditors). When a bank becomes insolvent, government regulators close the
bank, its assets are sold off, and its managers are fired. Since the owners of the Low Capital Bank will find
their investment wiped out, they would clearly have preferred the bank to have had a large enough cushion of
bank capital to absorb the losses, as was the case for the High Capital Bank. We therefore see an important
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION

rationale for a bank to maintain a high level of capital: A bank maintains bank capital to lessen the chance
that it will become insolvent.
ACTIVITY SHEET #2 - Part 2
(Evaluation)

General Instructions: This activity is composed of two parts: 1. Problem Solving, and 2. Multiple Choice.

B. For online students, when you’re done with this answer sheet, email this Activity Sheet to me. Details are as
follows:
Email Address : [email protected]
Subject : BFI Activity Sheet N0.2 – (YOUR NAME)

C. For offline students, return this activity sheet on designated drop off/pick up points placed in the envelope
provided to you. Deadline is approximately two weeks after drop off date of this activity sheet. Will inform you of
the of the day of pick up.

I. Problem solving: (Bank Balance Sheet)

1. Using the T-accounts of the First National Bank and the Second National Bank, describe what happens when Jane Brown writes a $50
check on her account at the First National Bank to pay her friend Joe Green, who in turn deposits the check in his account at the Second
National Bank.
2. The bank you own has the following balance sheet:

If the bank suffers a deposit outflow of $50 million with a required reserve ratio on deposits of 10%, what actions must you take
to keep your bank from failing?
3. If a deposit outflow of $50 million occurs, which balance sheet would a bank rather have initially, the balance sheet in Problem 2 or the
following balance sheet? Why?

II. MULTIPLE CHOICE. Select the best answer from the

choices given below:

1) Banks earn profits by selling ________ with attractive combinations of liquidity, risk, and return,
and using the proceeds to buy ________ with a different set of characteristics.
A) loans; deposits
B) securities; deposits
C) liabilities; assets
D) assets; liabilities
Answer: ____
2) In general, banks make profits by selling ________ liabilities and buying ________ assets.
A) long-term; shorter-term
B) short-term; longer-term
C) illiquid; liquid
D) risky; risk-free
Answer: ____
3) Holding all else constant, when a bank receives the funds for a deposited check,
A) cash items in the process of collection fall by the amount of the check.
B) bank assets increase by the amount of the check.
C) bank liabilities decrease by the amount of the check.
D) bank reserves increase by the amount of required reserves.
Answer: ____

Reference: Reference: Mishkin, F. S.,. (2019). The economics of money, banking and financial markets. Toronto: Pearson Addison Wesley.
12th edition

Prepared by: Noted by:

RAYNIEL D. ZABALA MELISSA S. CARBONELL

Assistant Professor I Department Chairperson - BSBA
 Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines

COLLEGE OF BUSINESS AND PUBLIC ADMINISTRATION