 How do banks work?  Chapter 10  Preconceptions  Soros funds alternative economics

The Bank Balance Sheet  Liabilities : Sources of funds  Checkable deposits 6%  Nontransaction deposits53%  Borrowings31%  Bank capital 10%  Note: in 1960  checkable deposits were 60% of liabilities

The Bank Balance Sheet  Assets: Uses of funds  Reserves8%  Securities22%  Loans 60%  Other assets10%

Basic Banking: Cash Deposit  Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits First National Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Checkable deposits +$100Reserves+$100Checkable deposits +$100

Basic Banking: Check Deposit First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves-$100Checkable deposits -$100 First National Bank AssetsLiabilities Cash items in process of collection +$100Checkable deposits +$100

Basic Banking: Making a Profit  The bank borrows short and lends long  Susceptibility to runs comes from this fact  Note that the process need not stop here  $90 is deposited somewhere  $81 in loan is possible First National Bank AssetsLiabilitiesAssetsLiabilities Required reserves +$10Checkable deposits +$100Required reserves +$10Checkable deposits +$100 Excess reserves +$90Loans+$90

Bank Management  Liquidity Management  Asset Management  Liability Management  Capital Adequacy Management  Credit Risk  Interest-rate Risk

Liquidity Management: Ample Excess Reserves  Suppose bank’s required reserves are 10%  If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet AssetsLiabilitiesAssetsLiabilities Reserves$20MDeposits$100MReserves$10MDeposits$90M Loans$80MBank Capital $10MLoans$80MBank Capital $10M Securities$10MSecurities$10M

Liquidity Management: Shortfall in Reserves  Reserves are a legal requirement and the shortfall must be eliminated  Excess reserves are insurance against the costs associated with deposit outflows  Alternatives: each is costly  Borrow: from other banks or the FED  Sell securities  Reduce Loans AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital $10M Securities$10MSecurities$10M

Liquidity Management: Borrowing  Cost incurred is the interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

Liquidity Management: Securities Sale  The cost of selling securities is the brokerage and other transaction costs AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

Liquidity Management: Federal Reserve  Borrowing from the Fed also incurs interest payments based on the discount rate AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrow from Fed$9M Securities$10MBank Capital$10M

Liquidity Management: Reduce Loans  Reduction of loans is the most costly way of acquiring reserves  Calling in loans antagonizes customers  Other banks may only agree to purchase loans at a substantial discount AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

Asset Management: Three Goals  Seek the highest possible returns on loans and securities  Reduce risk  Have adequate liquidity

Asset Management: Four Tools  Find borrowers who will pay high interest rates and have low possibility of defaulting  Purchase securities with high returns and low risk  Lower risk by diversifying  Balance need for liquidity against increased returns from less liquid assets

Liability Management  Recent phenomenon due to rise of money center banks  Expansion of overnight loan markets and new financial instruments (such as negotiable CDs)  Checkable deposits have decreased in importance as source of bank funds

Capital Adequacy Management  Bank capital helps prevent bank failure  The amount of capital affects return for the owners (equity holders) of the bank  Regulatory requirement

Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

Capital Adequacy Management: Returns to Equity Holders