1. Bank Balance Sheet

Financial Intermediaries

• Institutions (like banks, mutual funds, insurance companies, credit unions, and pension funds) which facilitate the transfer of funds from savers to borrowers in the economy

• They reduce information asymmetry and provide various financial services

• They are a key component of indirect finance

Indirect Finance

• Refers to the process of facilitating funds from savers to borrowers through intermediaries

The function of a bank

Commercial Banks:

• Raise funds mainly by issuing deposits and use these funds to make loans and buy securities

Investment Banks:

• Assist in capital raising and mergers and acquisitions

• Provides various other financial services

Mutual Funds

• Pool funds from multiple investors to invest in diversified portfolios

• This also provides access to a variety of assets

Functions of financial intermediation

• Risk transformation (diversifying risk by pooling funds from multiple investors and managing risk)

• Economies of scale (reducing transaction costs)

• Information analysis (reducing information asymmetry between lenders and borrowers)

• Maturity transformation (borrow short term and lend long term)

• Enhance efficiency of the financial system by connecting borrowers and lenders

• They help allocate capital to produce projects which contributes to economic growth

• Liquidity provision (ensure that funds are available for withdrawal whilst also funding long-term investments)

Financial Market

• A platform where individuals can trade financial assets

• Allows borrowers (issuers) to raise funds directly from investors (savers) by issuing securities, which investors can buy and sell amongst themselves)

• They also help to provide transparency as asset prices are determined through supply and demand dynamics

• Examples are the stock market, foreign exchange markets and commodity markets

Differences between Financial Markets and Financial Intermediaries

• Financial markets allow for direct transactions between buyers and sellers

• Intermediaries pool funds to diversify risk and provide loans whereas in markets individual’s decisions are relied upon

• Intermediaries possess expertise in evaluating and managing risk, whereas individual investors rely on their own research

Balance Sheet

• A statement that shows a firm or individual’s financial position at a particular time

• A banks primary sources of funds (liabilities: what the bank owes to other and allocates to shareholders) are assets and its primary uses of funds (assets: what the bank owns and is owed) are loans, which are both summarised in the balance sheet 

Asset

• Something of value that is owned

Liability

• Something that is owed

Bank Capital / Shareholder Equity / Bank Net Worth

• The difference between the value of a bank’s assets and the value of its liabilities

• Generally, [total assets = total liabilities + shareholders’ equity]

Insolvency

• A bank does not have enough assets to pay off all of its liabilities; thus shareholders equity < 0 

• The bank is unable to handle mass withdrawals

• Shareholders’ equity < 0 is a sign of insolvency but doesn’t always mean bank failure if a bank can restructure appropriately 

FED balance sheet

• It’s assets are securities and loans to financial institutions (which are called discount loans, on which they earn the discount rate)

• It’s liabilities are currency in circulation and reserves of commercial banks (deposits that banks hold at the FED, which traditionally has been legally required)

Reserves

• Checkable deposits that a bank holds (often as cash in vaults or a deposit at the FED) which act as a liquid asset which is constantly available to pay off liabilities (like deposits)

• Traditionally, banks are required to reserve a percentage of their checkable deposits to allow for deposit withdrawals and to prevent bank runs

• Total reserves = Required reserves + Excess Reserves

• In the US, reserves were required from 1913-2020, where they were set to 0% in 2020

Reserve Requirement

• Reserve Requirement = Reserve Requirement Ratio (%) x Bank Deposits (checkable)

• The Central Bank (FED) determines the ratio and informs commercial banks through announcements, circulars, and direct correspondence

Liquidity

• Refers to how easily an asset is transferred

• The most liquid assets are those which have minimal costs and procedures to transfer and move, like cash