6.4 Introducing a bank

important feature of banks

their net worth is typically small relative to their assets - unlike other businesses, they have liabilities ALMOST as big as their assets

rate of interest

= extra amount borrower promises to pay back / loan

for the bank, revenues from lending =

interest rate on loans x total lending

for the bank, payments to depositors =

interest rate on deposits x total deposits

so overall profit for a bank is

profit = revenues - costs

profit = revenues from lending - payments to depositors

profit = (interst rate on loans - interest rate on deposits) x total lending

how do banks increase profit?

the more they lend and the bigger tha gap between the interest rates on assets and liabilities

obvious issue w/ bilateral debt

an individual may not meet another individual who wants to borrow exactly how much they want to lend

two reasons why someone would prefer to lend to a bank rather than enter a bilateral debt contract

(1) might not meet someone who wants to borrow exactly how much you want to lend

(2) risk involved - always a risk that the borrower will default and pay less than the loan contract specifies

rate of return on a loan

= (total amount borrower actually pays back - loan) / loan

**this tells us that if the borrower repays in full, with interest, then the rate of return on a loan is equal to the itnerest rate, otherwise it’s lower

**if borrower doesn’t pay back anthing, ROR = -1 and lender loses all of it

how do banks deal w/ risk

banks diversify - they lend to many different borrowers at the same time - most repay

**they also account for this in the interes trate

if they think 90% will repay, and have interest rate of 20%, it can be condient that:

0.9 × 1.2 x loan = 1.08 x loan —> expected return of 8% which is way below 20%

the higher the probability of default

the lower the expected return

default premium

banks raise interest rate to add default premium which takes into account risk of ppl defaulting

capital adequacy requirements

even w/ diversification, banks can’t be certain about the proportion of loans that will be repaid so they’re obliged by law to have sufficient equity/net worth to meet their liabilitiesif the return on loans is lower than expected

**even if they have the minimum amt of net worth required, it’s still possible for there to be a banking crisis if large #s of borrowers are unable to repay their loans

a bank in which liabilities > assets can’t continue to operate

risk for the bank

(1) defaulting

(2) liquidity riskli

liquidity risk

banks tlel ppl their current account deposits are liwuid - but a bank can’t demand that a loan be repaid in full whenevr it wants

**if bank lends in form of mortgages, and a ton of people withdraw at the same time, they may not have the money bc mortgages are paid over long periods of time

bank run

something triggers a panic attack about the bank —> everyone withdraws and the bank may not be able to be liquid enough to handle that