The Economics of Banking (Summary)

The Bank Balance Sheet

  • Commercial banking involves taking deposits and making loans.
  • Balance sheets summarize a bank's assets and liabilities:
    • Assets = Liabilities + Shareholders’ Equity.

Bank Assets and Liabilities

  • Assets: Value owned by the bank (financial claims).
  • Liabilities: What the bank owes (financial claims on the bank).
  • Bank Capital: Difference between assets and liabilities (shareholders’ equity).

Liabilities

  • Checkable Deposits: Funds that depositors can withdraw via checks; includes demand deposits and NOW accounts.
  • Nontransaction Deposits: Include savings accounts and certificates of deposit (CDs).
  • Borrowings: Funds raised from other banks or the Federal Reserve to finance additional loans.

Assets

  • Reserves: Consist of vault cash and deposits held at the Federal Reserve.
  • Loans: Primary asset; types include commercial, consumer, and real estate loans.
  • Securities: Liquid assets, primarily U.S. Treasury securities, classified as secondary reserves.

Basic Operations of a Bank

  • T-account: Shows changes in balance sheet items.
  • Net Interest Margin: Difference between interest received and interest paid, a measure of bank profitability.
  • Return on Assets (ROA): Ratio of after-tax profit to bank assets.
  • Return on Equity (ROE): Ratio of after-tax profit to bank capital, related to ROA via leverage.

Managing Bank Risks

  • Liquidity Management: Ensures the bank can meet cash needs.
  • Asset Management: Aims to maximize returns, reduce risk, and maintain liquidity.
  • Liability Management: Focuses on optimal mix of borrowings.
  • Capital Adequacy Management: Ensures sufficient capital to prevent bank failures.
  • Credit Risk Management: Involves assessing the risk of borrower default and may include collateral requirements.
  • Interest-Rate Risk Management: Monitoring how changes in market rates affect bank profit and capital.

Historical Overview of U.S. Banking

  • Significant Acts:
    • Federal Reserve Act (1913): Established the Federal Reserve System.
    • Glass-Steagall Act (1933): Separated commercial banking from securities industry.
  • Recent Trends:
    • Financial deregulation and advancements in technology have transformed the banking landscape.
    • Increased importance of credit scoring and electronic banking.

Types of Banks

  • Commercial Banks: Largest segment, divided into money-center, regional, superregional, and community banks.
  • Thrift Institutions: Include savings banks and credit unions, focusing on savings and loans mainly for mortgages.

Banking Trends and Innovations

  • Financial Innovation: Drives changes in banking operations and products (e.g., electronic banking, derivatives).
  • Shadow Banking System: Non-bank financial intermediaries providing similar services without traditional banking regulations.
  • Responses to Financial Crises: Government interventions like TARP to stabilize banks during downturns.