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Introduction to Banking

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1 Introduction to Banking

2 Introduction A bank is a financial institution whose primary activity is to act as a payment agent for customers and to borrow and lend money. Banks provide funds to allow businesses to purchase inventory and collect back those funds with interest when the goods are sold. Banks are important players in the financial markets (because of the financial services they offer). For centuries, the banking industry only dealt with businesses, not consumers. Banks have influenced economies and politics for ages.

3 Introduction In some countries (Germany), banks own large corporations while in other countries (US), banks are prohibited to own non-financial corporations. In Japan, banks are usually the nexus of cross share holding entities known as zaibatsu. In France, bancassurance is highly present, as most banks offer insurance services (and now real estate services) to their clients. Nowadays, banking services have expanded to include services directed at individuals (and risk in these much smaller transactions are pooled).

4 Key Concepts 1. The General Banking Law (RA No. 8791) – an act providing for the regulation of the organization/operations of banks, quasi-banks, trust entities and for other purposes; est. Feb. 23, 1995. 2. The Bangko Sentral ng Pilipinas (BSP) – was rechartered on July 3, 1993, pursuant to the provisions of the 1987 Philippine Constitution and the New Central Bank Act of The Central Bank of the Phils. was established on January 3, 1949, as the country’s central monetary authority. 3. Bank Regulations – are a form of government regulation which subject banks to certain requirements, restrictions, and guidelines. 4. Bank secrecy – a legal principle under which banks are allowed to protect personal information of their customers.

5 Key Concepts 5. Capital requirement – is a bank regulation about how banks must handle their capital. In 1988, the Basel Accord provided a capital measurement for banks, it was eventually enhanced by Basel I & II. 6. Deposit account – a savings or current account in a bank that allows for deposit and withdrawal of funds by account holders. 7. Loan – is a type of debt. A loan entails the distirubution of financial assets over time between the lender and borrower. 8. Money laundering – the practice of engaging in financial transactions to conceal the source and destination of dirty money. 9. Universal bank – a bank that participates in all banking activities. A bank that is both commercial and investment bank.

6 What is Banking? Banking – is the business of receiving deposits from the general public, and then lending the funds to borrowers, or otherwise investing. Banking is about dealing in money (and its substitutes) and providing financial services.

7 Why Do We Study Banking? Banking is:
– the well-spring of the monetary bloodstream (i.e., life blood of business and industry). – an important component of the economic system of a country. – responsible for the rapid development of a country’s economy (by mobilizing savings into investments).

8 Why Does Banking Work? Answer: Because of the people's trust and confidence (that banks can grow and protect its money). Explanation: We give a bank our money to keep it safe for us, and then the bank turns around and gives it to someone else in order to make money for itself. Banks can legally extend considerably more credit than they have cash. Still, most of us have total trust in the bank's ability to protect our money and give it to us when we ask for it.

9 Historical Background of Banking
Banks originated in ancient Mesopotamia thousands of years ago (where royal palaces and temples provided secure places for the safekeeping of grains and commodities). In Egypt, the centralization of harvests in state warehouses also led to the development of a system of banking. Written orders for the withdrawal of separate lots of grains by owners soon became a more general method of payment of debts to other persons.

10 Historical Background of Banking
Although the first bank was established during the 14th century (Banco di San Giorgio) in Genoa, Italy, the principle of modern banking came during the English Civil War, 1642–1651. During the time, the goldsmiths' warehouses and safes were a secure place to deposit gold, bullion, jewelries, and coins. “Bank” originated from the Italian word “banko” because gold, jewelries, and other deposits were piled up on benches. At the end of the day, these valuables are kept under lock and key inside chests or vaults.

11 Historical Background of Banking
Goldsmith Bankers The goldsmiths kept their inventories in their vaults inside their warehouses. The extra spaces in the safes were rented by owners of coins, gold, and valuable items. A depositor receipt was issued whenever valuables are received. Instructions to goldsmiths to pay coins to another person subsequently developed into what is now known as checks.

12 Historical Background of Banking
How the banking system originated from the goldsmiths? Since coins are deposited with goldsmiths, depositors will eventually withdraw these coins whenever they purchase goods (or avail of services). This was a cumbersome task until the buyer of the goods just signs an endorsement at the back of the depository receipt, the seller accepts it as payment, then goes to the goldsmith to withdraw the coins. The convenience made by the endorsements made transactions between buyer and seller easier and resulted to a bigger volume of trade.

13 Historical Background of Banking
How banknotes originated from the goldsmiths? To facilitate a faster means of exchange, the goldsmiths replaced the depository receipt with bearer receipt (meaning the receipt can be transferred in a number of times without the need for a signed endorsement). There will be no need anymore for the bearer to withdraw the gold coins because he can use the bearer receipt (banknote) as payment for anything he buys.

14 Historical Background of Banking
How fractional banking originated from the goldsmiths? The total amount of gold coins/other valuables should equal to the total amount of receipts issued. If all holders of receipts withdraw all their deposits at the same, there will be enough coins/valuables to cover the withdrawals. Later, the smiths found out that simultaneous withdrawals rarely occur. So he thought he will issue more notes way above the amount of coins/valuables and no one will ever know (fractional banking).

15 The Nature of Banking Banks = use money and credit (as factors) in the development of exchange. = facilitates a form of exchange even w/o handling of money to make the exchange of goods take place smoothly. Recent changes: Before, only commercial banks could offer checking accounts. Today, other types of banks could do so. Before, only savings banks could provide housing loans. Today, commercial banks are into the same business

16 What is a Bank? A Bank – receives/holds deposits (of funds) from depositors, makes loans to borrowers, or otherwise invests these funds; organized in the form of a stock corporation. – derives profit from (a) interest income, (b) fees, and (c) charges. Official definition: “Banks” - shall refer to entities engaged in the lending of funds obtained in the form of deposits. - The General Banking Law of 2000 (RA No. 8791).

17 Bank’s Primary Function
The primary function of banks is to put their depositors' money to use by lending it out to others who can then use it to buy homes, send kids to college, business purposes, etc. Explanation: When you deposit your money in the bank, your money goes into a big pool of money and your account is credited with the amount of your deposit. When you write checks or make withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account.

18 Development of Banking Functions
The original concept of banking – just a place for safekeeping of money (issued receipts for money received). Later, conceived of as a credit institution. It loaned to credit seekers what it had previously received as deposits. Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages.

19 Formation of Banks The Free Banking Laws – are laws that existed during the 1800s that facilitated the formation of banks. Businesses could obtain banking charters by complying with a general bank incorporation law. In the country, we have BSP Circular-Letter, July 13, “Basic Guidelines in Establishing Banks” Note: An act of government legislation was not necessary to create a bank.

20 The Banker’s Dilemma How to loan money in such a way as:
To meet the demands of those who need credit. To keep enough funds to meet the demand of depositors for withdrawals.

21 Different Types of Banks
Universal bank Commercial bank Thrift bank Savings bank Cooperative bank Trust Company Rural bank 8. Building and Loan Association 9. Foreign bank 10. Private Development bank 11. Credit Union 12. Specialized Government bank 13. Islamic bank

22 Universal Bank Universal Banks – are “expanded” commercial banks or EKBs; represents the largest single group, resource-wise, of financial institutions in the country. Authorized to (1) engage in underwriting and other functions of investment houses, and (2) invest in the equity not only of allied undertakings but of non-allied enterprises (up to 100% of their equity). Developed in 1980, in which the resources of KBs are combined w/ those of investment houses, to allow greater capacity to generate long-term investment capital. 22

23 KBs and TBs Commercial Banks – are privately owned, local or foreign, most predominant; main functions include accepting deposits, lending, and safekeeping; also known as KBs. Thrift Banks – cater to small savings and provide loans at longer, easier terms to lower income groups. Loans are usually for basic social and economic needs and are granted to small producers. Thrift banks are composed of (a) Savings and Mortgage Banks (b) Stock Savings and Loan Associations (c) Private Development Banks (d) Cooperative Banks, and (e) Credit Unions. In addition to having the powers of a thrift bank, a commercial bank has the power to accept drafts and issue letter of credit; discount and negotiate promissory notes, drafts, bills of exchange, and other evidences of debt; accept or create demand deposits; receive other types of deposits and deposit substitutes; buy and sell foreign exchange and gold or silver bullion; acquire marketable bonds and other debt securities; and extend credit. A thrift bank has the power to accept savings and time deposits, act as a correspondent with other financial institutions and as a collection agent for government entities, issue mortgages, engage in real estate transactions and extend credit. In addition, thrift banks may also maintain checking accounts, act as a depository for government entities and local government units and engage in quasi-banking and money market operations subject to the approval of the Bangko Sentral Rural and cooperative banks are the more popular type of banks in the rural communities. Their role is to promote and expand the rural economy in an orderly and effective manner by providing the people in the rural communities with basic financial services. Rural and cooperative banks help farmers through the stages of production, from buying seedlings to marketing of their produce. Rural banks and cooperative banks are differentiated from each other by ownership. While rural banks are privately owned and managed, cooperative banks are organized/owned by cooperatives or federation of cooperatives. A rural bank has the power to provide adequate credit facilities to farmers and merchants or to cooperatives of such farmers and merchants and, in general, to the people of the rural communities of which the rural bank operates in. 23

24 What is a Savings Bank? A Savings Bank – originally founded for lower-income workers to save their money; originated in early 18th century. Note: A Savings and Loan Association – maybe owned by both shareholders and depositors (if they do, the word “mutual” is added). A Private Development Bank – is organized by private persons, residing in a given community, for the purpose of accumulating together their savings and other funds, so that these funds may be utilized as bank funds for economic development of the area in which the bank operates. 24

25 What is a Cooperative Bank and Credit Union?
A Cooperative Bank – is a a bank which belongs to its members, who are at the same time the owners/ customers of their bank (belonging to the same local/community or sharing common interest); established during the 1800s. Note: Cooperative Banks and Savings and Loan Associations were established to make it possible for factory workers and other lower-income workers to buy homes. The Credit Union – provides emergency loans for people who couldn't get loans from traditional lenders. These loans might be for things like medical costs or home repairs. 25

26 Trust Company A Trust Company – performs a fiduciary function, administers any trust, property, or deposit, for the use/benefit of an heir or beneficiary. Trust – the ability of banks to act as a trustee (i.e., someone who administers financial assets on behalf of another). A trustee – manages investments, keeps records, manages assets, prepares court accounting, pays bills and medical expenses, charitable gifts, inheritances, and/or distributes income or principal. 26

27 Rural Bank A Rural Bank – provides credit facilities to farmers, merchants (or cooperatives of farmers and merchants and), and people of rural communities. Rural Banks vs. Cooperative Banks Both are popular banks in the rural communities. Both promote and expand the rural economy in an orderly and effective manner by providing basic financial services. Both help farmers through the stages of production, from buying seedlings to marketing of their produce. They are differentiated by ownership. While rural banks are privately owned and managed, coop banks are organized/owned by cooperatives or federation of cooperatives. 27

28 Building and Loan Association and
Foreign Bank A Building and Loan Association – an association or corporation whose aim is to accumulate the savings of its stockholders and loan fund to other stockholders to encourage industry, frugality and home building among its stockholders. A Foreign Bank – is any bank formed, organized or existing, under any laws, other than the laws of the country. Foreign banks are required to secure license from a securities and exchange commission and central bank before transacting business in the country. In some cases, a bank organized domestically, may be treated as a foreign, if a majority of its capital stock is owned by foreigners. 28

29 Other Types of Banks An International Bank – is a financial entity that offers financial services, such as payment accounts and lending opportunities, to foreign clients (individuals and companies). Every international bank has its own policies outlining with whom they do business.

30 Why bank with international banks?
To invest in the economies of booming countries; international banks offer better interest rates than domestic banks, providing money-making opportunities for customers. Since international banks lend and borrow on international markets, they’re less affected by domestic interest fluctuations. To shelter money from their home country's income and estate taxes; keep it safe from lawsuits. Ex. the Cayman Islands, Panama and the Isle of Man.

31 Anonymous Banking In the past, many international banks offered relative anonymity and secrecy to their customers. Since the terror attacks of September 11, 2001, however, the US has worked with countries around the world to eliminate anonymous banking (the purpose being to uncover the identities of account-holders suspected of criminal activity). The completely anonymous, numbered Swiss account is a myth. There is always a record of who opened the account.

32 Other Types of Banks Specialized Government Banks – were established to finance the development of agricultural sector/other specific needs, ex. DBP and Al-Amanah Islamic Bank. Islamic Banks – as its name suggests, were established by Islamic groups and authorities.

33 Entry Regulation Commercial banks are regulated by government entities and require a license to operate. The regulator is typically a government owned bank (CB) and have the monopoly of issuing bank notes. Requirement for the issue of license include: a. Minimum capital b. Minimum capital ratio c. “Fit and Proper” rule – for bank owners, directors, officers, and employees d. Approval of the bank's business plan as being sufficiently prudent and plausible 33

34 Banking Channels Branch, banking center, or financial center ATM Mail
Telephone banking Online banking 34

35 Functions of Banks Creates money Payment mechanism
Pooling of savings – the deposit function Extension of credit – the loans and discount function Facilities for financing foreign trade Trust services Safekeeping of valuables Brokerage services

36 Creating Money When a bank grants loans to a producer, money is created and the production of goods is assured. When a bank lends through the issuance of its own PNs, money is created when the notes are used to buy goods/services.

37 Payment Mechanism Buyers and sellers are unable to meet personally, and if they do, neither would usually carry large sums of money. With banks, payment is not a problem. Commercial banks are equipped with an effective payment system, ex. check payment (with clearing), fund transfers, credit card payments, etc. Note: A credit card is not only a useful tool for credit but also as a means for payment since it allows the holder to borrow money and buy goods up to a certain limit w/o paying for them immediately.

38 Pooling of Savings Banks accept savings from customers.
Individual savings are pooled to form bigger amounts and made available to borrowers engaged in production/other ventures. With the use of the pooled funds, banks are able to extend loans for: – business expansion – purchase of real estate – purchase of consumer goods/services

39 Extension of Credit Banks are primary sources of credit.
Its lending activities enable people to obtain a higher standard of living (through increased production by the various industries, and increased investments in capital). Example: Loans to farmers will enable them to increase their output (he can buy seeds, feed, fertilizers, etc.) to produce food enough to feed an entire nation.

40 Financing Foreign Trades
When a buyer wants to make a purchase from a foreign country, the following can be a problem – acceptability of the buyer’s currency – assurance of payment and shipment of goods – language barriers With banks, such problems can be eliminated. Example: The buyer may buy foreign currency in a bank; use of letters of credit (LC). Note: An LC – is a written statement of the bank addressed to the seller guaranteeing that the bank will accept and pay a draft, up to a specified sum, if presented in accordance with the terms of the LC. If the seller shows proof (to the correspondent bank of the buyer) that the goods had already been shipped, he/she will receive payments.

41 Trust/Fiduciary Services
Banks serve as managers, administrators or trustees of estate of deceased persons, for the heirs, or for minors, absentees, or other incompetents who cannot manage their own properties. Notes: Trust – is a formal arrangement between trustor, trustee, and beneficiary. Trustor – creator of trust (could be individual or corp.). Trustee – agent of trustor in the management/ administration of certain property. Beneficiary – party for whom trust was created.

42 Why Banks Act in Fiduciary Capacity?
Banks are (relatively) permanent institutions – have perpetual successions. Safety – banks have fixed place of business, fixed hours, no speculation, no false accounts Skill – commands the necessary management skills Confidentiality – bank records and accounts are confidential Gov’t supervision – supervised by a regulatory authority Financial strength – under a strict capital and reserve requirements

43 Safekeeping of Valuables
Safekeeping services has become an important function of banks (although it is one of its oldest function). Individuals with valuables may not have the capability of keeping such valuables safe and secure. Classes of protecting valuables: Safe Deposit Boxes (SDB) – is a vault available to customers on a rental basis. Under this arrangement, only the customer is allowed to open the box. Access to the box is controlled by the bank. Safekeeping – the bank takes custody of the valuables and acts as agent to the customer. Ex. When a bond is placed under the care of the bank, the principal and interest will be collected by the bank upon maturity and these are deposited to the customer’s account.

44 Brokerage Services Some banks offer to buy and sell securities for customers. This service relieves the buyer and seller of securities with the difficulties of contacting a security dealer. As banks cover the entire country, the accessibility of such service becomes more economical and convenient to clients.

45 Other Functions of Banks
The clearance of checks function The note-issue function (performed by the central bank) The exchange function The financing foreign travel function The remittance and collection function Advisory function

46 Check Clearing Check Clearing – the movement of a check from the bank in which it was deposited to the bank of which it was drawn. This process (called “clearing cycle”) normally results in a credit of account at the bank of deposit, and an equivalent debit to the account of the bank in which it was drawn. Note: A Clearing House – is an association of banks established to facilitate the clearing of checks and other items (i.e., drafts, notes, etc.) among the members. Importance of a Clearing House Without a clearing house, it would be necessary for each bank to go to so many banks daily to cash or collect checks deposited with them by clients.

47 Notes Issuance In the 19th Century, notes issuance (currency and coins) had been one of the most important function of banks. However, this function was later transferred to a regulatory authority. In the country, it was on May 1, 1852, that the Banco Espanol-Filipino was authorized to issue Philippine notes. PNB at a much later date was also granted similar authority.

48 The Exchange Function Banks exchange and converts foreign currencies.
Types of Fx Rate: 1. Free rate 5. Sight rate 2. Official rate 6. Time rate 3. Spot rate 7. Market rate 4. Forward rate 8. OTC rate

49 Remittance & Collection
Banks remit amounts due to creditors upon order of debtors who are bank customers. Banks will collect accounts for creditors who are also bank customers Service fees, determined by contracts, are charged the clients for above bank services.

50 Advisory Function Banks, because of the technical training and experience of its personnel, are generally in a position to give advisory counsel to their customers with reference to such matters as investments, etc. Note: Many bank customers make use of this bank function.

51 Banks Activities Retail banking – deals directly with individuals and small businesses Business banking – provides services to mid-market businesses Corporate banking – directed at large business entities. Private banking – provides wealth management services to high net worth individuals and families Investment banking – assists corporations and governments raise capital or acquire funds.

52 Typical Services of a Bank
C. Trusteeship - Guardianship - Custodianship and safekeeping - Administratorship/ executorship - Life insurance trust - Escrow receivership - Investment management agreements - Common trust funds - Mortgage trust indenture - Management of pension funds D. Other Services - Collection - Custody of Securities - Investment in securities/CPs Deposit Account Services - Savings account - Checking account - Time deposit - Special savings account - Foreign currency deposit - ATM card B. Loan Services - Agricultural loans - Commercial loans - Industrial loans - Salary loans - Housing loans - Special financing loans - Loan syndication and co- financing

53 Sources of Bank Funds Investment of the shareholders.
Proceeds of the sale of bonds and other securities. Deposits made by bank customers. Undistributed profits from business operations. Trust funds. Derivative deposits. (Note: Banks give out loans in the form of credits to the checking accounts of borrowers.) Bank credit created through fractional reserve banking. Loans obtained by the bank from various sources (e.g., bank loans, CB loans, etc.). Draft – an order for the payment of money L/C – a document w/c provide a payment undertaking to a beneficiary Bill of exchange – an order to pay another person Allied undertaking – subs or affiliates Negotiable instrument – contract for payment of money that is unconditional and capable of transfer Security – negotiable instrument representing financial value. Debt security – bank notes, bonds, and debentures Equity security – ex. common stocks Debentures – secured by the debtor’s earning power, not a lien to property or assets 53

54 Uses of Bank Funds Loans Investments Project financing
Payments (bank operations) Service withdrawals Debt payments Other payments Draft – an order for the payment of money L/C – a document w/c provide a payment undertaking to a beneficiary Bill of exchange – an order to pay another person Allied undertaking – subs or affiliates Negotiable instrument – contract for payment of money that is unconditional and capable of transfer Security – negotiable instrument representing financial value. Debt security – bank notes, bonds, and debentures Equity security – ex. common stocks Debentures – secured by the debtor’s earning power, not a lien to property or assets 54

55 Profitability A bank is in the business of making money
out of other people's money. Draft – an order for the payment of money L/C – a document w/c provide a payment undertaking to a beneficiary Bill of exchange – an order to pay another person Allied undertaking – subs or affiliates Negotiable instrument – contract for payment of money that is unconditional and capable of transfer Security – negotiable instrument representing financial value. Debt security – bank notes, bonds, and debentures Equity security – ex. common stocks Debentures – secured by the debtor’s earning power, not a lien to property or assets 55

56 Power to Receive Deposits
The business of banking consists principally of receiving deposits for safekeeping (it is the distinctive feature of every bank). “Powers of a Commercial Bank – A commercial bank shall have x x x all such powers as may be necessary to carry on the business of commercial banking, such as x x x accepting or creating demand deposits; receiving other types of deposits and deposit subsitutes x x x.” Sec. 29, RA No General Banking Law.

57 What is a Deposit? Deposit – is money placed in a bank for safekeeping or to earn interest and to be used according to banking practice. Deposits are the lifeblood of a bank. A deposit is a contract between savers (creditors) and the bank (debtor), thus giving rise to a debtor- creditor relationship. Note: Bank deposits constitute one of the most influential factors in the whole financial system. They are not only the largest element of money stock, but at the same time form an important source of investment funds.

58 What is a Deposit? Although deposits serve as “assets” to banks, they are “liabilities” since they must be paid upon withdrawal request. Deposits are “balances due to customers”. Note: Bank deposits do not signify something that is actually or physically present (but may refer only to an entry in the books of banks recording its obligation to customers).

59 Forms of Deposits Cash (or cash items)
Checks issued by the bank or its branches (outright credit) Checks issued by other banks, local or regional (“clearing items”). Checks issued by other banks but cannot be credited right away (“items for collection”). Proceeds of loans and discounts Traveler’s checks Drafts Promissory Notes Money orders

60 Bank Deposits Savings Deposits – have no maturity dates and may be withdrawn from the bank at (almost) any time. Time Deposits – have specific maturity dates and carry significant interest forfeitures for early withdrawal. Note: Negotiable Certificate of Deposits – have fixed maturities and interest rates, but they are payable to “bearer” (holders can exchange them for money any time) and do not even require endorsements.

61 Other Types of Bank Deposits
Credit – cash or transfer items (such as checks) which are placed to a customer’s account in the bookkeeping department. Cash letter – is a deposit received by mail from other banks. Telegraphic Transfers – credits received by telegraph; also known as wire transfers. Deposit Substitutes – alternative form of obtaining funds from the public; represent all types of money market borrowings by banks like PNs, repos, CPs, etc.; sometimes referred to as derivative or secondary deposit.

62 Why Banks Accept Deposits?
Banks are businesses – they must be operated like any other businesses (strive to make their business profitable). A major portion of the bank’s income comes from lending, and to be able to do so, they must accept deposits. Since profits is a pre-requisite to survival, banks must engage in the generation of income. Note: Deposits constitute the bulk of the liabilities of a bank.

63 Deposit Insurance Deposit insurance – is an insurance coverage to protect/cover depositors’ deposits to banks. Depositors, if they heard of the slightest hint of trouble, “ran” to the bank to withdraw all of their money. Rumors make people uneasy about the security of their money in the bank. “Bank runs” have often than not, lead to failures of many banks and huge losses of savings for many people. Other banking insurance – were especially designed to cover deposits in cases of burglaries, robberies, vandalism, etc.

64 Deposit Reserves Reserves – the supply of cash and quick assets of banks. Required reserve – banks are required to set aside ready cash or near-cash items for ordinary or unusual withdrawals or demands for money by clients. Myths about the required reserve: The required reserve do not exist to protect against “runs”. Required reserves are to give the monetary authority control over the amount of lending and deposits that banks can create.

65 Deposit Reserves A bank’s solvency, in the long run, depends upon the quality of its assets. Two main classes of reserves: 1. Primary reserve – cash, deposits with other banks/central bank, readily marketable securities 2. Secondary reserve – securities for investment purposes.

66 Excess and Prudential Reserve
An Excess Reserve – are reserves that a bank (or depository institution) or the whole banking system holds above required reserves. Ex. If the required reserve of Bank X is P5 million but its actual reserve is P8 million the excess reserve is P3 million (P8,000,000 – P5,000,000). A Prudential Reserve – are reserves that a bank (or depository institution) voluntarily hold above required reserves in order to remain liquid to prepare for troubled- times.

67 Reserves Theories Liquidity Theory – a conservative bank prefers to keep highly liquid reserves (cash over stocks, bonds, or real estate). Shiftability Theory – a conservative bank allocates reserves where they can easily be shifted (from money market instruments, to loans or capital market instruments and vice versa). Diversity Theory – a conservative bank allocates reserves in adequately diversified investments. Note: In case of unavoidable loss in one, the profits in others may offset the losses.

68 What is a Bank Loan? A Bank Loan – is a loan made by a bank to be repaid with interest on or before a fixed date; a major function of commercial banks. The major portion of a bank’s income is generated through lending. “Productive” Loans In the early days, bank loans were only short-term used for productive purposes (ex. carrying a crop through harvest or carrying an inventory) and considered as self-liquidating. As soon as the crop, for example, was sold, the loan could be repaid.

69 Accounting for Bank Accounts
Bank statements are accounting records produced by banks under various accounting standards. Under GAAP there are two kinds of accounts: debit and credit. Credit accounts are Revenue, Equity and Liabilities. Debit Accounts are Assets and Expenses. This means you credit credit accounts to increase their balances and you debit debit accounts to increase their balances.

70 Bank’s Responsibility to Depositors and Stockholders
See to it that funds are protected from loss, by being cautious in their loans and investments, to such an extent as to assure profits. See to it that depositors’ claims for withdrawals are met upon demand, for ready repayment assures depositors of the use of their money in transactions worth many times the values of their deposits. See to it that bank funds are put to such productive uses as to yield satisfactory dividends to shareholders, and to increase the bank surplus account as to cushion the bank against loss during lean years.

71 Bank Crisis Banks are susceptible to different types of risks:
Liquidity risk – withdrawals beyond available funds Credit risk – those who owe money to the bank will not repay. Operational risk – improper operation of processing or management system resulting to loss, ex. Inexperienced personnel, unauthorized trading, easily accessed computer system, etc. Legal risk – arises from the possibility that an entity may not be able to enforce a contract (an illegality of the contract or the other party entered into the contract w/o proper authority or ultra vires). Interest rate risk – bank will be unprofitable in the rise of interest rate.

72 General Causes of Bank Failures
Severe business depressions Poor management. Large loans to officers and directors of the bank. Large loans to business concerns (in which the bank’s officers/directors are financially interested). Unexpected depreciation or decrease in the value of the securities held by the bank. Heavy withdrawals by depositors (bank run) as a result of loss of confidence in the bank or in its management.

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