BANKING
Liabilities A bank acquires funds by issuing (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.
Checkable Deposits Checkable deposits are bank accounts that allow the owner of the account to write checks to third parties.
TYPES: non-interest-bearing checking accounts (demand de- posits)
interest-bearing NOW (negotiable order of withdrawal)
accounts money market deposit accounts (MMDAs).
an asset for the depositor because it is part of his or her wealth. (the depositor can withdraw funds and the bank is obligated to pay) a liability for the bank. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest to have access to
Nontransaction Deposits The primary source of bank funds interests higher than checkable deposits
Two types of Nontransaction Deposits: 1. Savings Account- Funds can be deposited and withdrawn any time 2. Time Deposites - A fixed maturity rate (months-5yrs)
Borrowings Banks obtain funds through borrowing from other banks (mainly central banks) to meet the required deposits
Bank Capital The banks net worth total aasets - total liabilities = bank capital
Assets A bank uses the funds it has acquired by issueing liabilities to purchase income-earning assets. The'r assets are refered to as funds, and the interest payments earned on them are what enable banks to make profits
Reserves Deposites + currency (vault cash) (All banks hold some of the funds they acquire as deposites in an account) Earns low interest rate
Two Reasons for Reserves:
1. 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 (10 cents, for example) must be kept as reserves This fraction (10% in the example) is called the required reserve ratio.
2. 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because they are the most liquid of all bank assets and a bank can use them to meet its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account. Cash Items in Process of collection
Cash Items in Process of Collection A claim on another bank for funds that will be paid within a few days
Deposits at Other Banks Small banks holds deposites in larger banks in exchange for services
Securities made up entirely of debt instruments for commercial banks
EXAMPLE: US government and agency securities (most liquid)
State and local securities
Other Securities
Loans A liability for the individual or corporation receiving it, an asset for the bank Can not be turned into cash before the maturity period higher probability of default
Banks make profits by selling liabilities with one set of characteris- tics (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. FIf the bank produces desirable services at low cost and earns substantial income on its assets, it earns profits; if not, the bank suffers losses.
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: To make a profit, the bank must put tO productive use all or part of the $90 of excess reserves 1t has available. One way to do this is to invest in securities.
If a bank has ample excess reserves, a deposit outflows does not necessitate changes in other parts of its balance sheet.
Ways to combat lack of reserves
1. Bank acquire reserves to meet a deposite outflow by borrowing them from other banks in the federal funds market or from corporations
2. Banks sells their some of its securities to cover the deposit outflow
3.bank acquire reserves by borrowing from the Fed (discount loans) (the most costly way)
4.Banks call in or sell off loans
Asset management of banks
1 Banks try to find borrowers who will pay high interest rates and are unlikely to default on their loans
2 Banks try to purchase securities with high returns and low risk
3 Banks diversify by purchasing different types of assets (short/log tern) and approving many types of loans to a number of customers to overall lower risk
4 Bank must manage the liquidity of its assets so that it can meet deposit outflows and still satisfy it's reserve requirements without bearing huge costs
Bank's Capital
Banks decide their capital due to: helps prevent bank failure (by serving as a cushion and avoids insolvency) Amount of capital affects returns for the equity holders bank capital requirements is regulatory
Return on assets (ROA) is a good measure of bank profitability (how well the bank is run): FORMULA: ROA= net profit after taxes/assets
Return on equity (ROE) is the measure EQ holders care the most as it measures how much the bank is earning on their equity investment
FORMULA: ROE = net profit after tax/equity capital