Bank Balance Sheet Components: Liabilities, Deposit Fraud, and Equity Capital

Deposits as the Primary Bank Liability

• Definition and Core Nature of Deposits:

  • Deposits represent the largest form of liabilities for a commercial bank.

  • While often confusing to those outside of finance, deposits are liabilities because they are owned by the customers, not the bank. The bank owes these funds back to the depositor upon demand.

  • Depositors retain the right to clear checks or close their accounts at any time, requiring the bank to maintain liquidity to meet these obligations.

• Deposits as a Funding Source:

  • Deposits serve as the bank's primary funding source.

  • They are the essential "raw material" used to generate earning assets ($loans$ and $investments$).

  • Without a stable deposit base, banks would not achieve their typical levels of financial success.

• Asset Liability Management (ALM):

  • Understanding the "mix" and "stickiness" of deposits is critical to ALM and liquidity management.

  • Franchise Value: The value of a banking franchise is heavily based on its deposit mix, stability, and the level of "core" or relationship deposits.

  • Core Deposits: These are relationship-type deposits rather than purely transactional ones. Banks rely on these stable funds to facilitate long-term, illiquid loans.

• Historical Context and Market Shifts:

  • Post-COVID Era: For approximately ten years leading up to $2022$, many banks were flush with deposits due to COVID-related stimulus money and low activity.

  • Interest Rate Environment ($2022$): When interest rates began to rise, banks had to shift focus toward paying market rates on interest-bearing accounts to retain deposits.

  • $2023$ Bank Failures: The failure of Silicon Valley Bank (SVB) and other institutions in $2023$ caused a systemic worry regarding safety and soundness. This made deposit preservation a both micro and macro focus for bank management.

Deposit Utility and the Payment System

• Facilitation of Goods and Services:

  • Deposit accounts are vital to the economy as they facilitate the payment of goods and services.

  • They act as the infrastructure for tools like checks, Venmo accounts, and various payment apps.

  • Banks use these accounts to process payroll and pay business expenses.

• The Clearing System:

  • Banks work in tandem with the Federal Reserve and other institutions through a clearing and processing system.

  • Financial intermediaries facilitate transactions such as car payments, online debits, and wire transfers.

FDIC Insurance and Regulatory Limits

• Origin of FDIC Insurance:

  • Established during the Great Depression to restore public confidence in the banking system following massive losses.

• Current Coverage Limits:

  • The standard insurance limit is $\$250,000$ per depositor, per insured bank, for each account ownership category.

  • For non-person entities (Corporations, Partnerships, LLCs, etc.), the limit is strictly $\$250,000$.

  • The limit applies per charter; a depositor can have $\$250,000$ at different banks as long as they have separate charters (branches of the same institution do not count as separate entities for insurance purposes).

• Historical Changes in Limits:

  • Before the Great Recession, the limit was $\$100,000$.

  • During the Great Recession, regulators temporarily allowed $100\%$ insurance on all non-interest-bearing accounts regardless of balance to maintain stability. Once the crisis passed, the limit was permanently set at $\$250,000$.

• Strategies for Increasing Coverage (Individual Persons):

  • Individuals can exceed the $\$250,000$ limit by using different account ownership categories:

    • Single Account: Up to $\$250,000$.

    • Joint Account: A husband and wife can have a joint account insured up to $\$500,000$, plus $\$250,000$ each in their individual names.

    • Trust accounts and beneficiary designations can further expand these limits.

Categories of Bank Deposits

• Checking Accounts (Demand Deposits):

  • Can be withdrawn by check or transferred without notice.

  • Considered "on-demand" deposits.

  • Negotiable items that can be presented for payment to third parties.

• Savings Accounts:

  • No stated maturity date.

  • Earn interest.

  • Non-negotiable to third parties (you cannot write a check directly to a third party from a savings account).

  • Funds must be transferred to a checking account or wired out to be utilized for third-party payments.

• Certificates of Deposit (CDs):

  • Non-negotiable items with a stated maturity (e.g., a $1$-year CD paying $5\%$).

  • Funds are required to stay in the account until the maturity date.

Secured vs. Unsecured Deposits and Off-Balance Sheet Products

• Unsecured Deposits:

  • Most standard checking accounts are unsecured, meaning there is no specific collateral backing the deposit beyond FDIC insurance.

• Secured Deposits (Public Funds):

  • Governed by the Municipal Funds Act.

  • Applies to municipalities (e.g., the City of Huntsville).

  • Since non-personal accounts are capped at $\$250,000$ for insurance, banks must pledge liquid collateral (Treasuries or Fannie Mae securities) for any amount exceeding $\$250,000$.

  • This collateral is typically held by a third party (e.g., JPMorgan Chase) via a collateral agreement.

  • This creates a liquidity requirement for banks with large public fund bases.

• Off-Balance Sheet Products:

  • Used by large entities (e.g., energy companies) for treasury management.

  • Sweep Accounts: Excess cash not needed for daily payroll or payments is "swept" overnight into third-party investment accounts, such as a Fidelity treasury money market account.

  • These are liquid and safe but are not considered on-balance sheet deposits and do not carry FDIC insurance.

Operational Risk and Deposit Fraud

• Financial Impact:

  • Unlike loans, which have a loss reserve ($ALLL$), operational losses from fraud hit the bank's bottom line immediately as a direct expense on the income statement.

  • Direct Losses ($2008$): US banks faced over $\$2,800,000,000$ in direct losses due to deposit fraud.

  • Direct Losses ($2023$): Over $57\%$ of banks reported direct losses exceeding $\$500,000$, and over $25\%$ reported losses exceeding $\$1,000,000$.

  • Expense Multiplier: For every $\$1.00$ lost to fraud, banks incur approximately $\$4.36$ in related legal fees and recovery expenses (Source: American Bankers Association).

• Types of Fraud:

  • Check Fraud: Intercepting, stealing, or altering checks (e.g., check washing). Technology like laser printers allows fraudsters to replicate signatures and documents accurately.

  • Hot Checks: Writing a check for payment (e.g., $\$1,000$) knowing there are insufficient funds in the account. This can lead to criminal prosecution.

  • Chargebacks: Accepting a check for deposit that is later returned due to the issuer's insufficient funds.

  • Cyber/Electronic Fraud: Intercepting emails or taking over accounts to initiate fraudulent Wires or ACH transfers.

• Case Study: Regions Bank ($2023$):

  • Regions Bank reported $\$135,000,000$ in losses due to check fraud (not cyber) over a single six-month period.

• Mitigation and Evaluation:

  • Immediate Credit vs. Holds: Banks evaluate whether to provide immediate credit for a deposit based on the customer’s tenure, account performance, and whether the deposit size is typical for that account (e.g., a $\$50,000$ deposit in an account that averages $\$10,000$ will likely trigger a hold).

  • Electronic Safety: Banks use verification, authentication, and dual control procedures for electronic transactions.

Equity Capital

• Definition: The difference between a bank's total assets and its total liabilities.

• Purpose:

  • Acts as a buffer to absorb losses.

  • Serves as a centerpiece for regulatory policy to discourage excessive risk-taking.

  • Fundamental for survival and growth.

• Regulatory Framework:

  • Risk-Based Capital (introduced in the $1990s$): Concepts that mandate capital levels must match the specific risk profile of the balance sheet.

  • Well-Capitalized Status: Banks strive to maintain this status to avoid regulatory actions or forced closure.

• Composition of Capital:

  • Common Stock and Preferred Stock: Carried on the balance sheet at par value.

  • Retained Earnings: The accumulation of net income since the bank's inception, minus any dividends paid to shareholders.

Real-World Balance Sheet Example: Bank of Oklahoma

• Asset Side Categories:

  • Interest-bearing cash and cash equivalents.

  • Trading securities (categorized as Available for Sale or Trading).

  • Loans: Commercial, Commercial Real Estate, and Individual loans.

  • Allowance for Loan Losses: Listed as a contra-account (negative value) to show "Loans net of allowance."

  • Non-earning assets: Cash and due from banks (clearing accounts), derivatives, and other assets.

• Liability and Equity Side Categories:

  • Deposits: Demand deposits, Interest-bearing transactions, Savings, and Time deposits (CDs).

  • Federal Funds Purchased.

  • Other borrowings.

  • Stockholders' Equity (Capital).