CHAPTER 10

BANKING AND THE MANAGEMENT OF

FINANCIAL INSTITUTIONS?
Chapter 10: Banking and the Management of
Financial Institutions?
 The Bank Balance Sheet
is a list of the bank’s assets and liabilities.

A bank’s balance sheet is also a list of its sources of bank funds

(liabilities) and uses to which the funds are put (assets).

Total assets = Total liabilities + Capital

 The Bank Balance Sheet
 Banks make profits by earning interest on their asset holdings of
securities and loans that is higher than the interest and other
expenses on their liabilities.
Banks receive deposits and make loans.
 The Bank Balance Sheet
Assets Liabilities

1. Reserves 1. Checkable deposits.

2. Cash items in process of 2.Nontransaction deposits.
collection 3. Borrowings
3. Deposits at other banks 4. Bank capital
4. Securities
5. Loans
6. Other assets
 The Bank Balance Sheet
 In the previous figure, on the assets side: As we move from top
to bottom, profitability increases and liquidity decreases. In the
first elements of assets, liquidity increases and profitability
decreases, while in the last elements, liquidity decreases and
profitability increases. There is an inverse relationship between
profitability and liquidity.
 The Bank Balance Sheet: liabilities
Liabilities: are the sources of funds the bank uses.

 A bank acquires funds by selling liabilities, such as deposits,

which are the sources of funds the bank uses.

 The funds obtained from issuing liabilities are used to

purchase income-earning assets.
 The Bank Balance Sheet: liabilities
1. Checkable deposits are bank accounts that allow the owner of the
account to write checks to third parties. Checkable deposits includes:
o non–interest-bearing checking accounts (demand deposits).
o interest-bearing NOW (negotiable order of withdrawal) accounts.
o money market deposit accounts (MMDAs)

Checkable deposits and money market deposit accounts are payable on demand.

A checkable deposit is an asset for the depositor, and checkable deposits are a liability for the bank.


 The Bank Balance Sheet: liabilities
2. Nontransaction deposits are the primary source of bank funds.
Owners cannot write checks on nontransaction deposits, but the
interest rates paid on these deposits are usually higher than those on
checkable deposits.

There are two basic types of nontransaction deposits:

 savings accounts

 time deposits
 The Bank Balance Sheet: liabilities
3. Borrowings, Banks also obtain funds by borrowing from the central
banks, other banks, and corporations.

 Borrow from other banks is the first choice for a bank facing a reserve
deficiency.
 The Bank Balance Sheet: liabilities
4. Bank Capital(the bank’s net worth), The final category on the
liabilities side of the balance sheet is bank capital, the bank’s net worth,
which equals the difference between total assets and liabilities.
o Holding large amounts of bank capital helps prevent bank failures because it can be
used to absorb the losses resulting from bad loans.
 Chapter 10
Assets: Bank assets are uses of funds, and the interest payments earned on them
are what enable banks to make profits.

1. Reserves All banks hold some of the funds they acquire as deposits in an
account at the central bank.

 Reserves are these deposits plus currency that is physically held by banks (called
vault cash).
 Chapter 10
 The bank has two types of reserves:

(1) required reserve and (2) excess reserve

 Although reserves earn a low interest rate, banks hold them for two reasons:

First, some reserves, called required reserves, are held because of reserve
requirements, the regulation that for every dollar of checkable deposits at a bank, a
certain fraction must be kept as reserves. This fraction (10% in the example) is
called the required reserve ratio.
 Chapter 10
 That is, the bank keeps 10% of the total deposits in the bank’s vault
as a reserve (called required reserve or legal reserve).

 Banks hold additional reserves, called excess reserves, because they are the
most liquid of all bank assets, and a bank can use them to meet its obligations
when Funds are withdrawn.
 Chapter 10
 Suppose the required reserve ratio is 10 percent. Assume that the banking
system has $20 million in deposits and $5 million in reserves. Find the required
reserves, excess reserves, and the maximum amount by which demand deposits
could expand.

The required reserve ratio gives the percent of deposits that banks must hold as reserves. It is the ratio of
required reserves to deposits. If the required reserve ratio is 10 percent this means that banks must hold
10 percent of their deposits as required reserves. If deposits are $20 million, then $2 million ($20
million x .10) must be held as required reserves.
 Chapter 10
 The required reserves = 20 × 0.1 = $2 million

 Excess reserves are reserves over and above required reserves. If total reserves are $5 million and
required reserves are $2 million, then excess reserves are $3 million ($5 million less $2 million).

 Total reserves = required reserves + Excess reserves

5 = 2 + Excess reserves

Excess reserves = $3 million

 Chapter 10
 If the banking system were to loan out its entire excess reserves, the money supply would expand by $3
million. However, as this money circulates through the system, there would be further increases in the
money supply. The maximum amount by which demand deposits can expand is given by the equation:

 the expansion of demand deposits = the excess reserves in the banking system / the required reserve ratio.

= 3 / 0.1 = $30 million.

the maximum amount by which demand deposits can expand is equal to $30 million ($3/0.10).
 Chapter 10
2. Cash items in process of collection:

Suppose that a check written on an account at another bank is deposited in your

bank and the funds for this check have not yet been received (collected) from the
other bank. The check is classified as a cash item in process of collection, and it is an
asset for your bank because it is a claim on another bank for funds that will be paid
within a few days.
 Chapter 10
3. Deposits at Other Banks:

Many small banks hold deposits in larger banks in exchange for a variety of services,
including check collection, foreign exchange transactions, and help with securities
purchases. This is an aspect of a system called correspondent banking.

Collectively, reserves, cash items in process of collection, and deposits at other banks
are referred to as cash items.
 Chapter 10
4. Securities: A bank’s holdings of securities are an important income-earning
asset.
 Banks invest in various types of securities as part of their overall portfolio
management strategy. These securities can include government bonds, corporate
bonds, mortgage-backed securities, and other financial instruments.
 Securities are often more liquid than other types of assets, such as loans. This
liquidity allows banks to quickly convert their securities into cash if needed,
helping them manage liquidity risk and meet short-term obligations.
 Chapter 5: What is Money?
5. Loans: Banks make their profits primarily by issuing loans.

 A loan is a liability for the individual or corporation receiving it, but

an asset for a bank, because it provides income to the bank.
 Loans are typically less liquid than other assets, because they cannot
be turned into cash until the loan matures.
 Loans also have a higher probability of default than other assets.
Because of the lack of liquidity and higher default risk, the bank earns
its highest return on loans.
 Chapter 10

6. Other Assets The physical capital (bank buildings, computers,

and other equipment) owned by banks is included in this category.
 Basic Banking

We study how a bank manages its assets and liabilities to make the
highest profit.

 Asset transformation
o 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.
 Basic Banking

o A savings deposit held by one person can provide the funds that enable
the bank to make a mortgage loan to another person.

o The bank has transformed the savings deposit (an asset held by the
depositor) into a mortgage loan (an asset held by the bank).

o The banks tend to “borrow short and lend long” because they make long-term
loans and fund them by issuing short-dated deposits.
 Basic Banking

- To make the analysis of the operation of a bank more concrete, let

us use a tool called T-account.

T-account analysis
- Amira deposit of $ 100 cash into first national bank.
 Basic Banking

- An increase in the bank reserve = increase in CD and Because vault cash is

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

 an increase in the bank’s reserves equal to the increase in checkable deposits.

 Basic Banking
 Conclusion: when bank receives deposits, reserves by equal
amount; when bank loses deposits, reserves by equal amount.
 Basic Banking

 Deposits of $ 100 cash into first national bank. If the fraction is 10%, first
national bank required reserve have increase by $10.


 Basic Banking

 If the central bank transfers the $100 of reserves from the Second Bank to the
First Bank and the final balance sheet position of the two banks are as follows:
 Basic Banking: Make a Profit
 To make a profit, the bank must put to productive use all or part of
the $90 of excess reserves it has available. One way to do this is to
invest in securities. The other is to make loans; as we have seen, loans
account for approximately 60% of the total value of bank assets.

 Let’s assume that the bank chooses not to hold any excess reserves
but to make loans instead.
 Basic Banking: Make a Profit
 As we can see, $10 of the deposit must remain with the bank to meeting
central bank regulations. Now, the bank is free to work with the $90 in
its asset transformation function. In this case, the bank loans the $90 to
its customers.
 Deposits of $ 100 cash into first national bank. If the bank choose not to
hold any excess reserves but to make loans instead, the T-account would
be as follows:
 Basic Banking: Make a Profit
 The bank is now making a profit because it holds short-
term liabilities, such as checkable deposits, and uses the
proceeds to fund longer-term assets, such as loans with
higher interest rates.