1. How has technology changed the banking industry?

2 Written Assignment Unit 4

After reading all the available information carefully, prepare a two page (double-spaced) essay presenting the
consulting firm and answer the following questions:
Home » Accounting Tutorials » Balance Sheet Tutorials » Bank Balance Sheet vs Company Balance Sheet
Bank Balance Sheet vs Company Balance Sheet
Difference Between Bank Balance Sheet and Company Balance Sheet
The preparation of a bank balance sheet is really complicated since the banking institutions will need to calculate
their net loans and it is really time consuming and the items recorded in this balance sheet are loans, allowances,
Short Term Loans, etc whereas the preparation of a company’s balance sheet is not that complicated and time-
taking and it records items like assets, liabilities and net worth.

Before we go into the nitty-gritty of the balance sheet of the bank and of any regular company, first, we need to
look into the nature of each.

The bank acts as an intermediary between two parties. The job of a bank is to assist the company in which it can
help. Bank makes profits from the spread between the rate it receives and the rate it pays.

On the other hand, a company operates to produce goods or services and ultimately sell these goods or services
to another business, end customer, or to Government. The objective of running a regular company is to generate
and maximize wealth for its shareholders.

As the nature of both of these entities is different, it makes sense to prepare a unique balance sheet for each of
them.

Bank-Balance-Sheet-and-Company-Balance-Sheet

Bank Balance Sheet vs. Company Balance Sheet [Infographics]

The differences between Bank Balance Sheet vs. Company Balance Sheet are as follows –
Structure of Bank’s Balance Sheet
Bank Balance Sheet is prepared differently from the Company Balance Sheet. The first few items on the Balance
Sheet of a Bank are similar to the Balance Sheet of a Regular Company. For example, cash, securities, etc. come
under assets in the Bank’s Balance Sheet.
Schedules in a Bank Balance Sheet
In a Bank Balance Sheet, schedules are mentioned because schedules refer to additional information. Key
schedules that are being used in the bank balance sheets are –
 Deposits
 Borrowings
 Capital
 Reserves & Surpluses
  Cash on hand
 Investments
 Liabilities
Average balance
One of the unique characteristics of the bank balance sheet is that all the balances that take place into the balance
sheet are average amounts. Taking average amounts provide a better idea about the financial affairs of the bank.
However, what separates the bank from the other regular company is that the bank takes more risk than any
regular company.
Loans
This is one of the ways banks earn money. Banks provide loans to various customer segments. Two of the basic
loans bank offers are personal loans and mortgage loans. Personal loans are given with an interest rate and
without any mortgage. Usually, the interest rate remains higher in personal loans.
Mortgage loans are given against a mortgage. As the loans are offered against a mortgage, the interest rate is
usually lower here. But if the individual is unable to pay off the loans, the mortgage is claimed by the bank.
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Banks also create an allowance in the balance sheet to cover losses from the loans (if any) and change the
structure of this allowance depending on the economic factors going on in the market.
Short term investments
To the banks, short term investments are also of utter importance. That’s they include cash, securities under short
term investments. These short term investments do three things –
 First, short term investments lower the duration of total assets.
 Second, short term investments also lower the chances of loan default risk.
 And lastly, short term investments also increase liquidity.
 
Format and example of Balance Sheet of Bank
ABC Bank Balance Sheet

Particulars Schedule Amount (in US $, millions)

Assets

Cash balances 8 30,000

Residential mortgage 25,000

Federal funds sold & securities purchased 11,000

Commercial 23,000

Investments 7 43,000
Credit Card 3500

Advances 6 12,500

Commercial Loans 2,000

Leases 4,500

Accumulated Depreciation 5 500

Allowance for loan & leases losses 4 7,000

Total Assets 162,000

Liabilities

Savings 45,000

Time Deposits 34,000

Money Market Deposits 26,000

Federal funds sold and purchased under agreement to

5,500
repurchase

Interest bearing long term debt 3 13,000

Non-interest bearing liabilities 2 3,500

Shareholders’ Equity 1 35,000

Total liabilities & shareholders’ equity  162,000

Structure of the Company’s Balance Sheet

The balance sheet of a regular company is similar to a simple balance sheet format.
The balance sheet of a regular company will balance two sides – assets and liabilities.
For example, if a company takes a loan from a bank of $50,000, the transaction will take place on the balance
sheet in the following manner –
 Firstly, on the “asset” side, we will include “Cash” of $50,000.
 Secondly, on the “liability” side, we will include “Debt” of $50,000.
For one transaction, there are two consequences, and these two are balanced by the balance sheet.
Let’s now understand “assets” and “liabilities.”
Assets
Under “assets,” first, we will talk about “current assets.” Current assets are assets that can be liquidated quickly
in cash. Here are the items that come under current assets –
 Cash & Cash Equivalents
  Short-term investments
 Inventories
 Trade & Other Receivables
 Prepayments & Accrued Income
 Derivative Assets
 Current Income Tax Assets
 Assets Held for Sale
 Foreign Currency
 Prepaid Expenses
Here’s an example for you –

  A (in US $) B (in US $)

Cash 4500 5600

Cash Equivalent 6500 3400

Accounts Receivable 7000 8000

Inventories 8000 7000

Total Current Assets 26,000 24,000

Now, let’s talk about “non-current assets.”

Non-current assets are also called fixed assets. They will pay you off for more than one year, and they can’t
easily be liquidated.
Under “non-current assets,” we would include the following items –
 Property, plant, and equipment
 Goodwill
 Intangible assets
 Investments in associates & joint ventures
 Financial assets
 Employee benefits assets
 Deferred tax assets
If we add both current assets and non-current assets, we will get the total assets of a regular company.
Liabilities
In Liabilities also, we will start with “current liabilities.”
Current liabilities are liabilities that can be paid in a very short duration. Here are the items that we would
include under current liabilities –
 Financial Debt (Short term)
 Trade & Other Payables
  Provisions
 Accruals & Deferred Income
 Current Income Tax Liabilities
 Derivative Liabilities
 Accounts Payable
 Sales Taxes Payable
 Interests Payable
 Short Term Loan
 Current maturities of long term debt
 Customer deposits in advance
 Liabilities directly associated with assets held for sale
Now we will look at an example of current liabilities –

  M (in US $) N (in US $)

Accounts Payable 21000 31600

Current Taxes Payable 17000 11400

Current Long-term Liabilities 8000 12000

Total Current Liabilities 46000 55000

We will now have a look at the “non-current liabilities.” These liabilities are long term liabilities, which the
company will pay off within a long period of time.
In “non-current liabilities,” we will include the following –
 Financial Debt (Long term)
 Provisions
 Employee Benefits Liabilities
 Deferred Tax Liabilities
 Other Payables
By adding the “current liabilities” and “non-current liabilities,” we will get “total liabilities.”
To complete the balance sheet of a regular company, we have only one thing is left. And that is “shareholders’
equity.”
Shareholders’ Equity
Shareholders’ equity is the statement that includes that share capital and all other related adjustments. Here’s a
format of shareholders’ equity –

Shareholders’ Equity

Paid-in Capital:  
Common Stock ***

Preferred Stock ***

Additional Paid-up Capital:  

Common Stock **

Preferred Stock **

Retained Earnings ***

(-) Treasury Shares (**)

(-) Translation Reserve (**)

If we add total liabilities and shareholders’ equity, we will get a number, and that should match with the total
assets.
Now we will look at the format and example of the balance sheet of a regular company.
Format & example of the balance sheet of a regular company
Balance Sheet of ABC Company

2016 (In US $) 2015 (In US $)

Assets    

Current Assets 250,000 550,000

Investments 36,00,000 39,50,000

Plant & Machinery 22,00,000 15,60,000

Intangible Assets 35,000 25,000

Total Assets 60,85,000 60,85,000

Liabilities    

Current Liabilities 175,000 210,000

Long term Liabilities 85,000 175,000

Total Liabilities 260,000 385,000

Stockholders’ Equity
Preferred Stock 450,000 450,000

Common Stock 49,95,000 50,00,000

Retained Earnings 380,000 250,000

Total Stockholders’ Equity 58,25,000 57,00,000

Total liabilities & Stockholders’ Equity 60,85,000 60,85,000

Key differences – Bank Balance Sheet vs. Company Balance Sheet

The differences between Bank Balance Sheet vs. Company Balance Sheet are as follows –
 Balance Sheet of Bank is quite different than the Balance Sheet of a Regular Company in the approach
of preparation. Both are prepared quite differently.
 Assets and liabilities of a bank are much different than the assets and liabilities of a regular company.
That’s why even if the arrangement of the bank and a regular company is similar, the items are always
different.
 In the balance sheet of the banks, the average balances are summed up and recorded. It gives a better
framework for the financial performance of the banks. On the other hand, the balance sheet of a regular
company takes the ending balance from trail balance. Trial balance is prepared from the ledger
accounts. And then, from trail balance, the ending balance is transferred to the balance sheet of a
regular company.
 To show new information, the balance of the bank used “schedules.” To show new information, on the
other hand, a balance sheet of a regular company uses “notes.”
 To prepare a balance sheet of a bank, an accountant has to go through a lot of information. S/he needs
to look through the short term investments of the banks, the loans (personal & mortgage), deposits,
interest paid & received, etc. That’s why preparing the balance sheet of a bank is quite cumbersome. On
the other hand, preparing the balance sheet of a regular company is pretty easy. All you need to do is to
find out current assets, fixed assets, current liabilities, non-current liabilities, and shareholders’ equity.
And you would be able to prepare the balance sheet easily.
 Banks take more risks than any other company. That’s why in the balance sheet of the bank, a separate
provision (allowance) is created to cover the losses on loans. There’re provisions for bad debts or
creditors in the balance sheet of a regular company, but they are not similar to allowance created in the
bank’s balance sheet.
 There are many economic factors that affect the balance sheet of a bank. But in the case of a regular
company, rarely external events affect the preparation of the balance sheet.
Also, check out the Balance Sheet vs. Consolidated Balance Sheet
Bank Balance Sheet vs. Company Balance Sheet [Comparison Table]

Basis for Comparison

– Bank Balance Sheet vs. Balance Sheet of Bank Balance Sheet of a Regular Company
Company Balance Sheet 

Bank’s balance sheet is prepared as The company’s balance sheet is prepared as

1.    Definition per the mandate by the Regulatory per the regulation of the International
Authorities Accounting Standards Board (IASB).

2.    Objective The main objective is to showcase The main objective is to reflect the accurate
an accurate trade-off between financial picture of an organization to the
 bank’s profit and risk. stakeholders.

The scope of the company balance sheet is

The scope of the bank’s balance
the much broader sense it is applicable to all
3.    Scope sheet is limited since it’s applicable
sorts of companies (manufacturing, auto,
only for banks.
etc.).

Assets = Liabilities + Shareholders’

4.    Equation – Bank Equity
Balance Sheet vs. Company (* Bank’s assets & liabilities are Assets = Liabilities + Shareholders’ Equity
Balance Sheet  much different than any regular
company)

The preparation of a balance sheet

for a bank is quite complex since The preparation of the company balance
5.    Complexity
the bank needs to calculate the “net sheet is much simpler.
loans.”

Bank’s balance sheet needs a lot of The company’s balance sheet doesn’t take a
6.    Time consumption
time to prepare. lot of time to prepare.

7.    Key concepts – Bank Loans, Short-term

Balance Sheet vs. Company investments, Provision for losses on Assets, Liabilities, & Shareholders’ Equity.
Balance Sheet  loans;

Bank balance sheet mentions The company balance sheet mentions its
8.    Mentionable document
reference through “schedules.” reference via “notes.”

In the bank balance sheet, the type In the company balance sheet, the type of
9.    Type of balance
of balance is the average balance. balance is ending balance.

Conclusion – Bank Balance Sheet vs. Company Balance Sheet

If you look at a balance sheet of a regular company, you will have a surface level idea about how a balance sheet
works. The balance sheet of the bank is arranged in a similar manner, but the items under the heads are different.
Moreover, banks use the average balance for their balance sheets, which is quite unique if we compare it with the
regular company operations.
Even if these balance sheets are quite different in scope, the objective of both of them is quite similar, i.e., to
disclose an accurate picture of the financial affairs of the organization.
 
Bank Balance Sheet vs. Company Balance Sheet Video
 
Recommended Articles
This has been a guide to Bank Balance Sheet vs. Company Balance Sheet. Here we discuss the top difference
between bank balance sheet and company balance sheet along with infographics and comparison table. You may
also have a look at the following articles –
 1. A bank balance sheet is different from that of a typical company. Explain the differences.
2. Looking on the percentages, comment on the Assets and Liabilities of the above Balance sheet. Why do
bank managers prefer Loans over Securities? Why is cash only 4%?

Understanding a Bank's
Balance Sheet
In the first part of a series, we untangle a bank's assets.

Emil Lee

(Emil-Lee)

Updated: Oct 2, 2018 at 2:56PM

Published: Jan 5, 2007 at 12:00AM

A bank's balance sheet is different from that of a typical company. You won't find
inventory, accounts receivable, or accounts payable. Instead, under assets, you'll see
mostly loans and investments, and on the liabilities side, you'll see deposits and
borrowings.

Let's take a closer look at the balance sheet of the fictional First Bank of the Fool.

Cash
Surprisingly, cash represents only 2% of assets. That's because the bank wants to put its money to work
earning interest. If the bank simply sticks its cash in a vault and forgets about it, it will have a hard time
making a profit. Thus, a bank keeps most of its money tied up in loans and investments, which are called
"earning assets" in bank-speak because they earn interest.

IMAGE SOURCE: GETTY IMAGES.

Securities
Banks don't like putting their assets into fixed-income securities, because the yield isn't that great.
However, investment-grade securities are liquid, and they have higher yields than cash, so it's always
prudent for a bank to keep securities on hand in case they need to free up some liquidity.
If we look at Wells Fargo (NYSE:WFC), SunTrust (NYSE:STI), and M&T Bank (NYSE:MTB), we
see that approximately 16%, 18%, and 17% of their earning assets are invested in securities. The purpose
of holding securities is for the bank to have safe, liquid assets available, so the banks primarily hold
Treasuries and agency debt (such as Fannie Mae- or Freddie Mac-issued debt), which yield around the
rate of the current long-term U.S. Government yield, anywhere from 4%-6%.

Loans
Loans represent the majority of a bank's assets. A bank can typically earn a higher interest rate on loans
than on securities, roughly 6%-8%. You can find detailed information about the rates earned on loans and
investments in the financial statements.

Loans, however, come with risk. If the bank makes bad loans to consumers or businesses, the bank will
take a hit when those loans aren't repaid.

Because loans are a bank's bread and butter, it's critical to understand a bank's book of loans. In their 10-
Ks, banks characterize their loans in easily readable charts. For example, M&T tells us that at the end of
its last fiscal year, 36.5% of its average loans were backed by commercial real estate. We also know that
of its $14.5 billion in commercial real estate loans outstanding, $4.5 billion was in metropolitan New
York.

I was once interested in Corus Bankshares (NASDAQ:CORS). However, as of last quarter, 94% of its
loans were for condo construction and conversions, and 33% of its loans were in Florida. Although I've
heard good things about Corus' management, and the valuation looked compelling, I took a pass --
foreseeing the future of the Florida condo market is outside my circle of competence. However, bank
stock investors have to read the financials if they want to know the kind of risks to which they are
exposed.

Other assets
Other assets, including property and equipment, represent only a small fraction of assets. A bank can
generate large revenues with very few hard assets. Compare this to some other companies, where plant,
property, and equipment (PP&E) is a major asset.

Company PP&E / Assets

SunTrust 1.0%

Home Depot (NYSE:HD) 49.8%

Procter & Gamble (NYSE:PG) 13.7%

Disney (NYSE:DIS) 28.6%

Data provided by CapitalIQ, a division of Standard & Poor's.

Assessing assets
A bank's assets are its meal ticket, so it's critical for investors to understand how its assets are invested,
how much risk they are taking, and how much liquidity the bank has in securities as a shield against
unforeseen problems. In general, investors should pay attention to asset growth, the composition of assets
between cash, securities, and loans, and the composition of the loan book. Also, investors should note a
bank's asset/equity (equity multiplier) ratio, which measures how many times a dollar of equity is
leveraged. As of the latest quarter, SunTrust, Wells Fargo, and Corus had equity multiplier ratios of 9.9,
10.7, and 12.25. Paying attention to these trends is critical to making money in bank stocks.

Now that we've looked at a bank's assets, we also need to understand the other side of the balance sheet --
its liabilities, which are how a bank finances its assets. Check back tomorrow for the whole story.
Your essay will be graded on the following:

 Describe the difference for at least three of the balance sheet elements

 Discuss at least 2 of why bank managers prefer loans over securities.

 Use at least one example in the essay.

 Organization Grading Guidelines: Presentation is very effective and presented in a logical format with a
clear beginning, middle, and end. There is a clear statement of ideas and smooth transitions. The writer has
stated the main idea clearly and has provided relevant details. The main idea is clearly conveyed in a
presentation that is highly relevant and interesting. The student provides evidence of thoughtful input.
Details are rich and appropriate. Spelling, punctuation, and capitalization are virtually always correct.

3
Learning Journal Unit 4
Prepare a (approximately) 200 word summary of the textbook material you have read this week on Chapter 9.
This summary should be entered in your learning journal this week.

This is “Bank Management”, chapter 9 from the book Finance, Banking, and

Money (v. 1.1). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free,
please see the project's home page. You can browse or download additional books
there. To download a .zip file containing this book to use offline, simply click here.

Chapter 9Bank Management

CH A PTER OBJ ECTIV ES

By the end of this chapter, students should be able to:

1. Explain what a balance sheet and a T-account are.

2. Explain what banks do in five words and also at length.
3. Describe how bankers manage their banks’ balance sheets.
4. Explain why regulators mandate minimum reserve and capital ratios.
5. Describe how bankers manage credit risk.
6. Describe how bankers manage interest rate risk.
7. Describe off-balance sheet activities and explain their importance.

9.1 The Balance Sheet

LEA RN IN G OBJ ECTIV E

1. What is a balance sheet and what are the major types of bank assets and
liabilities?

Thus far, we’ve studied financial markets and institutions from 30,000 feet. We’re
finally ready to “dive down to the deck” and learn how banks and other financial
intermediaries are actually managed. We start with the balance sheet, a financial
statement that takes a snapshot of what a company owns (assets) and owes
(liabilities) at a given moment. The key equation here is a simple one:

ASSETS (aka uses of funds) = LIABILITIES (aka sources of funds) + EQUITY (aka
net worth or capital).

Figure 9.1 Bank assets and liabilities

Figure 9.2 Assets and liabilities of U.S. commercial banks, March 7, 2007

Figure 9.1 "Bank assets and liabilities" lists and describes the major types of bank
assets and liabilities, and Figure 9.2 "Assets and liabilities of U.S. commercial banks,
March 7, 2007" shows the combined balance sheet of all U.S. commercial banks on
March 7, 2007.

Stop and Think Box

In the first half of the nineteenth century, bank reserves in the United States
consisted solely of full-bodied specie (gold or silver) coins. Banks pledged to pay
specie for both their notes and deposits immediately upon demand. The government
did not mandate minimum reserve ratios. What level of reserves do you think those
banks kept? (Higher or lower than today’s required reserves?) Why?

With some notorious exceptions known as wildcat banks, which were basically
financial scams, banks kept reserves in the range of 20 to 30 percent, much higher
than today’s required reserves. They did so for several reasons. First, unlike today,
there was no fast, easy, cheap way for banks to borrow from the government or other
banks. They occasionally did so, but getting what was needed in time was far from
assured. So basically borrowing was closed to them. Banks in major cities like Boston,
New York, and Philadelphia could keep secondary reserves, but before the advent of
the telegraph, banks in the hinterland could not be certain that they could sell the
volume of bonds they needed to into thin local markets. In those areas, which
included most banks (by number), secondary reserves were of little use. And the
potential for large net outflows was higher than it is today because early bankers
sometimes collected the liabilities of rival banks, then presented them all at once in
the hopes of catching the other guy with inadequate specie reserves. Also, runs by
depositors were much more frequent then. There was only one thing for a prudent
early banker to do: keep his or her vaults brimming with coins.

KEY TA KEA WA YS

 A balance sheet is a financial statement that lists what a company owns (its
assets or uses of funds) and what it owes (its liabilities or sources of funds).
 Major bank assets include reserves, secondary reserves, loans, and other assets.
 Major bank liabilities include deposits, borrowings, and shareholder equity.

9.2 Assets, Liabilities, and T-Accounts

LEA RN IN G OBJ ECTIV ES

1. In five words, what do banks do?

2. Without a word limitation, how would you describe what functions they fulfill?
As Figure 9.1 "Bank assets and liabilities" and Figure 9.2 "Assets and liabilities of U.S.
commercial banks, March 7, 2007" show, commercial banks own reserves of cash and
deposits with the Fed; secondary reserves of government and other liquid securities;
loans to businesses, consumers, and other banks; and other assets, including
buildings, computer systems, and other physical stuff. Each of those assets plays an
important role in the bank’s overall business strategy. A bank’s physical assets are
needed to conduct its business, whether it be a traditional brick-and-mortar bank, a
full e-commerce bank (there are servers and a headquarters someplace), or a hybrid
click-and-mortar institution. Reserves allow banks to pay their transaction deposits
and other liabilities. In many countries, regulators mandate a minimum level of
reserves, called required reserves. When banks hold more than the reserve
requirement, the extra reserves are called excess reserves. Because reserves pay no
interest, American bankers generally keep excess reserves to a minimum, preferring
instead to hold secondary reserves like U.S. Treasuries and other safe, liquid,
interest-earning securities. Banks’ bread-and-butter asset is, of course, their loans.
They derive most of their income from loans, so they must be very careful who they
lend to and on what terms. Banks lend to other banks via the federal funds market,
but also in the process of clearing checks, which are called “cash items in process of
collection.” Most of their loans, however, go to nonbanks. Some loans are
uncollateralized, but many are backed by real estate (in which case the loans are
called mortgages), accounts receivable (factorage), or securities (call loans).

Stop and Think Box

Savings banks, a type of bank that issues only savings deposits, and life insurance
companies hold significantly fewer reserves than commercial banks do. Why?

Savings banks and life insurance companies do not suffer large net outflows very
often. People do draw down their savings by withdrawing money from their savings
accounts, cashing in their life insurance, or taking out policy loans, but remember
that one of the advantages of relatively large intermediaries is that they can often
meet outflows from inflows. In other words, savings banks and life insurance
companies can usually pay customer A’s withdrawal (policy loan or surrender) from
customer B’s deposit (premium payment). Therefore, they have no need to carry large
reserves, which are expensive in terms of opportunity costs.

Where do banks get the wherewithal to purchase those assets? The right-hand side of
the balance sheet lists a bank’s liabilities or the sources of its funds. Transaction
deposits include negotiable order of withdrawal accounts (NOW) and money market
deposit accounts (MMDAs), in addition to good old checkable deposits. Banks like
transaction deposits because they can avoid paying much, if any, interest on them.
Some depositors find the liquidity that transaction accounts provide so convenient
they even pay for the privilege of keeping their money in the bank via various fees, of
which more anon. Banks justify the fees by pointing out that it is costly to keep the
books, transfer money, and maintain sufficient cash reserves to meet withdrawals.

The administrative costs of nontransaction deposits are lower so banks pay interest
for those funds. Nontransaction deposits range from the traditional passbook savings
account to negotiable certificates of deposit (NCDs) with denominations greater than
$100,000. Checks cannot be drawn on passbook savings accounts, but depositors can
withdraw from or add to the account at will. Because they are more liquid, they pay
lower rates of interest than time deposits (aka certificates of deposit), which impose
stiff penalties for early withdrawals. Banks also borrow outright from other banks
overnight via what is called, strangely, the federal funds market, and directly from
the Federal Reserve via discount loans (aka advances). They can also borrow from
corporations, including their parent companies if they are part of a bank holding
company.

That leaves only bank net worth, the difference between the value of a bank’s assets
and its liabilities. Equity originally comes from stockholders when they pay for shares
in the bank’s initial public offering (IPO) or direct public offering (DPO). Later, it
comes mostly from retained earnings, but sometimes banks make a seasoned offering
of additional stock. Regulators watch bank capital closely because, as we learned
in Chapter 8 "Financial Structure, Transaction Costs, and Asymmetric Information",
the more equity a bank has, the less likely it is that it will fail. Today, having learned
this lesson the hard way, U.S. regulators will close a bank down well before its equity
reaches zero. Provided, that is, they catch it first. Even well-capitalized banks can fail
very quickly, especially if they trade in the derivatives market, of which more below.

At the broadest level, banks and other financial intermediaries engage in asset
transformation. In other words, they sell liabilities with certain liquidity, risk,
return, and denominational characteristics and use those funds to buy assets with a
different set of characteristics. Intermediaries link investors (purchasers of banks’
liabilities) to entrepreneurs (sellers of banks’ assets) in a more sophisticated way than
mere market facilitators like dealer-brokers and peer-to-peer bankers do (see Chapter
8 "Financial Structure, Transaction Costs, and Asymmetric Information").

More specifically, banks (aka depository institutions) turn short-term deposits into
long-term loans. In other words, they borrow short and lend long. This, we’ll see,
makes bank management tricky business indeed. Other financial intermediaries
transform assets in other ways. Finance companies borrow long and lend short,
rendering their management much easier than that of a bank. Life insurance
companies sell contracts (called policies) that pay off when or if (during the policy
period of a term policy) the insured party dies. Property and casualty companies sell
policies that pay if some exigency, like an automobile crash, occurs during the policy
period. The liabilities of insurance companies are said to be contingent because they
come due if an event happens rather than after a specified period of time.

Asset transformation and balance sheets provide us with only a snapshot view of a
financial intermediary’s business. That’s useful, but, of course, intermediaries, like
banks, are dynamic places where changes constantly occur. The easiest way to
analyze that dynamism is via so-called T-accounts, simplified balance sheets that
list only changes in liabilities and assets. By the way, they are called T-accounts
because they look like a T. Sort of. Note in the T-accounts below the horizontal and
vertical rules that cross each other, sort of like a T.

Suppose somebody deposits $17.52 in cash in a checking account. The T-account for
the bank accepting the deposit would be the following:
 Some Bank
Assets Liabilities
Reserves +
Transaction deposits +$17.52
$17.52

If another person deposits in her checking account in Some Bank a check for
$4,419.19 drawn on Another Bank,If that check were drawn on Some Bank, there
would be no need for a T-account because the bank would merely subtract the
amount from the account of the payer, or in other words, the check maker, and add it
to the account of the payee or check recipient. the initial T-account for that
transaction would be the following:

Some Bank
Assets Liabilities
Cash in collection +
Transaction deposits +$4,419.19
$4,419.19

Once collected in a few days, the T-account for Some Bank would be the following:

Some Bank
Assets Liabilities

Cash in collection −

$4,419.19

Reserves +$4,419.19

The T-account for Another Bank would be the following:

Another Bank
Assets Liabilities
Reserves −$4,419.19
Transaction deposits −
$4,419.19

Gain some practice using T-accounts by completing the exercises.

 EX ERCISES

Write out the T-accounts for the following transactions.

1. Larry closes his $73,500.88 account with JPMC Bank, spends $500.88 of that
money on consumption goods, then places the rest in W Bank.
2. Suppose regulators tell W Bank that it needs to hold only 5 percent of those
transaction deposits in reserve.
3. W Bank decides that it needs to hold no excess reserves but needs to bolster its
secondary reserves.
4. A depositor in W bank decides to move $7,000 from her checking account to a CD
in W Bank.

5. W Bank sells $500,000 of Treasuries and uses the proceeds to fund two
$200,000 mortgages and the purchase of $100,000 of municipal bonds.

(Note: This is net. The bank merely moved $100,000 from one type of security
to another.)

KEY TA KEA WA YS

 In five words, banks lend (1) long (2) and (3) borrow (4) short (5).
 Like other financial intermediaries, banks are in the business of transforming
assets, of issuing liabilities with one set of characteristics to investors and of buying
the liabilities of borrowers with another set of characteristics.
 Generally, banks issue short-term liabilities but buy long-term assets.
 This raises specific types of management problems that bankers must be
proficient at solving if they are to succeed.

9.3 Bank Management Principles

LEA RN IN G OBJ ECTIV E

1. What are the major problems facing bank managers and why is bank
management closely regulated?
Bankers must manage their assets and liabilities to ensure three conditions:

1. Their bank has enough reserves on hand to pay for any deposit outflows (net
decreases in deposits) but not so many as to render the bank unprofitable.
This tricky trade-off is called liquidity management.
2. Their bank earns profits. To do so, the bank must own a diverse portfolio of
remunerative assets. This is known as asset management. It must also obtain
its funds as cheaply as possible, which is known as liability management.
3. Their bank has sufficient net worth or equity capital to maintain a cushion
against bankruptcy or regulatory attention but not so much that the bank is
unprofitable. This second tricky trade-off is called capital adequacy
management.

In their quest to earn profits and manage liquidity and capital, banks face two major
risks: credit risk, the risk of borrowers defaulting on the loans and securities it owns,
and interest rate risk, the risk that interest rate changes will decrease the returns on
its assets and/or increase the cost of its liabilities. The financial panic of 2008
reminded bankers that they also can face liability and capital adequacy risks if
financial markets become less liquid or seize up completely (q* = 0).

Stop and Think Box

What’s wrong with the following bank balance sheet?

Flower City Bank Balance

June 31, 2009 (Thousands USD)
Sheet
Liabilities Assets
Reserves $10 Transaction deposits $20
Security $10 Nontransaction deposits $50
Lones $70 Borrowings (−$15)
Other assets $5 Capitol worth $10
Totals $100 $100
There are only 30 days in June. It can’t be in thousands of dollars because this bank
would be well below efficient minimum scale. The A-L labels are reversed but the
entries are okay. By convention, assets go on the left and liabilities on the right.
Borrowings can be 0 but not negative. Only equity capital can be negative. What is
“Capitol worth?” A does not equal L. Indeed, the columns do not sum to the
purported “totals.” It is Loans (not Lones) and Securities (not Security). Thankfully,
assets is not abbreviated!

Let’s turn first to liquidity management. Big Apple Bank has the following balance
sheet:

Big Apple
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $10 Transaction deposits $30
Securities $10 Nontransaction deposits $55
Loans $70 Borrowings $5
Other assets $10 Capital $10
Totals $100 $100

Suppose the bank then experiences a net transaction deposit outflow of $5 million.
The bank’s balance sheet (we could also use T-accounts here but we won’t) is now like
this:

Big Apple
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $5 Transaction deposits $25
Securities $10 Nontransaction deposits $55
Loans $70 Borrowings $5
Other assets $10 Capital $10
Totals $95 $95

The bank’s reserve ratio (reserves/transaction deposits) has dropped from 10/30 = .
3334 to 5/25 = .2000. That’s still pretty good. But if another $5 million flows out of
the bank on net (maybe $10 million is deposited but $15 million is withdrawn), the
balance sheet will look like this:

Big Apple
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $0 Transaction deposits $20
Securities $10 Nontransaction deposits $55
Loans $70 Borrowings $5
Other assets $10 Capital $10
Totals $90 $90

The bank’s reserve ratio now drops to 0/20 = .0000. That’s bound to be below the
reserve ratio required by regulators and in any event is very dangerous for the bank.
What to do? To manage this liquidity problem, bankers will increase reserves by the
least expensive means at their disposal. That almost certainly will not entail selling
off real estate or calling in or selling loans. Real estate takes a long time to sell, but,
more importantly, the bank needs it to conduct business! Calling in loans (not
renewing them as they come due and literally calling in any that happen to have a call
feature) will likely antagonize borrowers. (Loans can also be sold to other lenders, but
they may not pay much for them because adverse selection is high. Banks that sell
loans have an incentive to sell off the ones to the worst borrowers. If a bank reduces
that risk by promising to buy back any loans that default, that bank risks losing the
borrower’s future business.) The bank might be willing to sell its securities, which are
also called secondary reserves for a reason. If the bankers decide that is the best path,
the balance sheet will look like this:

Big Apple
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $10 Transaction deposits $20
Securities $0 Nontransaction deposits $55
Loans $70 Borrowings $5
Other assets $10 Capital $10
 Big Apple
Balance Sheet (Millions USD)
Bank
Totals $90 $90

The reserve ratio is now .5000, which is high but prudent if the bank’s managers
believe that more net deposit outflows are likely. Excess reserves are insurance
against further outflows, but keeping them is costly because the bank is no longer
earning interest on the $10 million of securities it sold. Of course, the bank could sell
just, say, $2, $3, or $4 million of securities if it thought the net deposit outflow was
likely to stop.

The bankers might also decide to try to lure depositors back by offering a higher rate
of interest, lower fees, and/or better service. That might take some time, though, so in
the meantime they might decide to borrow $5 million from the Fed or from other
banks in the federal funds market. In that case, the bank’s balance sheet would
change to the following:

Big Apple
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $5 Transaction deposits $20
Securities $10 Nontransaction deposits $55
Loans $70 Borrowings $10
Other assets $10 Capital $10
Totals $95 $95

Notice how changes in liabilities drive the bank’s size, which shrank from $100 to
$90 million when deposits shrank, which stayed the same size when assets were
manipulated, but which grew when $5 million was borrowed. That is why a bank’s
liabilities are sometimes called its “sources of funds.”

Now try your hand at liquidity management in the exercises.

EX ERCISES
 Manage the liquidity of the Timberlake Bank given the following scenarios. The legal
reserve requirement is 5 percent. Use this initial balance sheet to answer each
question:

Timberlake
Balance Sheet (Millions USD)
Bank
Assets Liabilities
Reserves $5 Transaction deposits $100
Securities $10 Nontransaction deposits $250
Loans $385 Borrowings $50
Other assets $100 Capital $100
Totals $500 $500

1. Deposits outflows of $3.5 and inflows of $3.5.

2. Deposit outflows of $4.2 and inflows of $5.8.

3. Deposit outflows of $3.7 and inflows of $0.2.

4. A large depositor says that she needs $1.5 million from her checking account,
but just for two days. Otherwise, net outflows are expected to be about zero.

5. Net transaction deposit outflows are zero, but there is a $5 million net
outflow from nontransaction deposits.

Asset management entails the usual trade-off between risk and return. Bankers want
to make safe, high-interest rate loans but, of course, few of those are to be found. So
they must choose between giving up some interest or suffering higher default rates.
Bankers must also be careful to diversify, to make loans to a variety of different types
of borrowers, preferably in different geographic regions. That is because sometimes
entire sectors or regions go bust and the bank will too if most of its loans were made
in a depressed region or to the struggling group. Finally, bankers must bear in mind
that they need some secondary reserves, some assets that can be quickly and cheaply
sold to bolster reserves if need be.

Today, bankers’ decisions about how many excess and secondary reserves to hold is
partly a function of their ability to manage their liabilities. Historically, bankers did
not try to manage their liabilities. They took deposit levels as given and worked from
there. Since the 1960s, however, banks, especially big ones in New York, Chicago, and
San Francisco (the so-called money centers), began to actively manage their liabilities
by

a. actively trying to attract deposits;

b. selling large denomination NCDs to institutional investors;
c. borrowing from other banks in the overnight federal funds market.

Recent regulatory reforms (discussed in greater detail in Chapter 11 "The Economics

of Financial Regulation") have made it easier for banks to actively manage their
liabilities. In typical times today, if a bank has a profitable loan opportunity, it will
not hesitate to raise the funds by borrowing from another bank, attracting deposits
with higher interest rates, or selling an NCD.

That leaves us with capital adequacy management. Like reserves, banks would hold
capital without regulatory prodding because equity or net worth buffers banks (and
other companies) from temporary losses, downturns, and setbacks. However, like
reserves, capital is costly. The more there is of it, holding profits constant, the less
each dollar of it earns. So capital, like reserves, is now subject to minimums called
capital requirements.

Consider the balance sheet of Safety Bank:

Safety Bank Balance Sheet (Billions USD)

Assets Liabilities
Reserves $1 Transaction deposits $10
Securities $5 Nontransaction deposits $75
Loans $90 Borrowings $5
Other assets $4 Capital $10
Totals $100 $100

If $5 billion of its loans went bad and had to be completely written off, Safety Bank
would still be in operation:
 Safety Bank Balance Sheet (Billions USD)
Assets Liabilities
Reserves $1 Transaction deposits $10
Securities $5 Nontransaction deposits $75
Loans $85 Borrowings $5
Other assets $4 Capital $5
Totals $95 $95

Now, consider Shaky Bank:

Shaky Bank Balance Sheet (Billions USD)

Assets Liabilities
Reserves $1 Transaction deposits $10
Securities $5 Nontransaction deposits $80
Loans $90 Borrowings $9
Other assets $4 Capital $1
Totals $100 $100

If $5 billion of its loans go bad, so too does Shaky.

Shaky Bank Balance Sheet (Billions USD)

Assets Liabilities
Reserves $1 Transaction deposits $10
Securities $5 Nontransaction deposits $80
Loans $85 Borrowings $9
Other assets $4 Capital −$4
Totals $95 $95

You don’t need to be a certified public accountant (CPA) to know that red numbers
and negative signs are not good news. Shaky Bank is a now a new kind of bank,
bankrupt.
Why would a banker manage capital like Shaky Bank instead of like Safety Bank? In a
word, profitability. There are two major ways of measuring profitability: return on
assets (ROA) and return on equity (ROE).

ROA = net after-tax profit/assets

ROE = net after-tax profit/equity (capital, net worth)

Suppose that, before the loan debacle, both Safety and Shaky Bank had $10 billion in
profits. The ROA of both would be 10/100 = .10. But Shaky Bank’s ROE, what
shareholders care about most, would leave Safety Bank in the dust because Shaky
Bank is more highly leveraged (more assets per dollar of equity).

Shaky Bank ROE = 10/1 = 10

Safety Bank ROE = 10/10 = 1

This, of course, is nothing more than the standard risk-return trade-off applied to
banking. Regulators in many countries have therefore found it prudent to mandate
capital adequacy standards to ensure that some bankers are not taking on high
levels of risk in the pursuit of high profits.

Bankers manage bank capital in several ways:

a. By buying (selling) their own bank’s stock in the open market. That reduces
(increases) the number of shares outstanding, raising (decreasing) capital and
ROE, ceteris paribus
b. By paying (withholding) dividends, which decreases (increases) capital,
increasing (decreasing) ROE, all else equal
c. By increasing (decreasing) the bank’s assets, which, with capital held constant,
increases (decreases) ROE

These same concepts and principles—asset, liability, capital, and liquidity

management, and capital-liquidity and capital-profitability trade-offs—apply to other
types of financial intermediaries as well, though the details, of course, differ.
 KEY TA KEA WA YS

 Bankers must manage their bank’s liquidity (reserves, for regulatory reasons and
to conduct business effectively), capital (for regulatory reasons and to buffer against
negative shocks), assets, and liabilities.
 There is an opportunity cost to holding reserves, which pay no interest, and
capital, which must share the profits of the business.
 Left to their own judgment, bankers would hold reserves > 0 and capital > 0, but
they might not hold enough to prevent bank failures at what the government or a
country’s citizens deem an acceptably low rate.
 That induces government regulators to create and monitor minimum
requirements.

9.4 Credit Risk
LEA RN IN G OBJ ECTIV E

1. What is credit risk and how do bankers manage it?

As noted above, loans are banks’ bread and butter. No matter how good bankers are
at asset, liability, and capital adequacy management, they will be failures if they
cannot manage credit risk. Keeping defaults to a minimum requires bankers to be
keen students of asymmetric information (adverse selection and moral hazard) and
techniques for reducing them.

Bankers and insurers, like computer folks, know about GIGO—garbage in, garbage
out. If they lend to or insure risky people and companies, they are going to suffer. So
they carefully screen applicants for loans and insurance. In other words, to reduce
asymmetric information, financial intermediaries create information about them.
One way they do so is to ask applicants a wide variety of questions.

Financial intermediaries use the application only as a starting point. Because risky

applicants might stretch the truth or even outright lie on the application,
intermediaries typically do two things: (1) make the application a binding part of
the financial contract, and (2) verify the information with disinterested third
parties. The first allows them to void contracts if applications are fraudulent. If
someone applied for life insurance but did not disclose that he or she was suffering
from a terminal disease, the life insurance company would not pay, though it might
return any premiums. (That may sound cruel to you, but it isn’t. In the process of
protecting its profits, the insurance company is also protecting its policyholders.) In
other situations, the intermediary might not catch a falsehood in an application until
it is too late, so it also verifies important information by calling employers (Is John
Doe really the Supreme Commander of XYZ Corporation?), conducting medical
examinations (Is Jane Smith really in perfect health despite being 3' 6'' tall and
weighing 567 pounds?), hiring appraisers (Is a one-bedroom, half-bath house on the
wrong side of the tracks really worth $1.2 million?), and so forth. Financial
intermediaries can also buy credit reports from third-party report providers like
Equifax, Experian, or Trans Union. Similarly, insurance companies regularly share
information with each other so that risky applicants can’t take advantage of them
easily.

To help improve their screening acumen, many financial intermediaries specialize.

By making loans to only one or a few types of borrowers, by insuring automobiles in a
handful of states, by insuring farms but not factories, intermediaries get very good at
discerning risky applicants from the rest. Specialization also helps to keep monitoring
costs to a minimum. Remember that, to reduce moral hazard (postcontractual
asymmetric information), intermediaries have to pay attention to what borrowers
and people who are insured do. By specializing, intermediaries know what sort of
restrictive covenants (aka loan covenants) to build into their contracts. Loan
covenants include the frequency of providing financial reports, the types of
information to be provided in said reports, working capital requirements, permission
for onsite inspections, limitations on account withdrawals, and call options if
business performance deteriorates as measured by specific business ratios. Insurance
companies also build covenants into their contracts. You can’t turn your home into a
brothel, it turns out, and retain your insurance coverage. To reduce moral hazard
further, insurers also investigate claims that seem fishy. If you wrap your car around
a tree the day after insuring it or increasing your coverage, the insurer’s claims
adjuster is probably going to take a very close look at the alleged accident. Like
everything else in life, however, specialization has its costs. Some companies
overspecialize, hurting their asset management by making too many loans or issuing
too many policies in one place or to one group. While credit risks decrease due to
specialization, systemic risk to assets increases, requiring bankers to make difficult
decisions regarding how much to specialize.

Forging long-term relationships with customers can also help financial

intermediaries to manage their credit risks. Bankers, for instance, can lend with
better assurance if they can study the checking and savings accounts of applicants
over a period of years or decades. Repayment records of applicants who had
previously obtained loans can be checked easily and cheaply. Moreover, the
expectation (there’s that word again) of a long-term relationship changes the
borrower’s calculations. The game, if you will, is no longer a one-off prisoner’s
dilemma,http://plato.stanford.edu/entries/prisoner-dilemma/ where it is in both
parties’ interest to defect, but rather a repeated game, where the optimal strategy is
one of tit for tat—cooperate until the other guy
defects.http://www.gametheory.net/dictionary/TitforTat.html

One way that lenders create long-term relationships with businesses is by providing
loan commitments, promises to lend $x at y interest (or y plus some market rate)
for z years. Such arrangements are so beneficial for both lenders and borrowers that
most commercial loans are in fact loan commitments. Such commitments are
sometimes called lines of credit, particularly when extended to consumers.

Bankers also often insist on collateral—assets pledged by the borrower for

repayment of a loan. When those assets are cash left in the bank, the collateral is
called compensating or compensatory balances. Another powerful tool to combat
asymmetric information is credit rationing, refusing to make a loan at any interest
rate (to reduce adverse selection) or lending less than the sum requested (to reduce
moral hazard). Insurers also engage in both types of rationing, and for the same
reasons: people willing to pay high rates or premiums must be risky, and the more
that is lent or insured (ceteris paribus) the higher the likelihood that the customer
will abscond, cheat, or set aflame, as the case may be.

As the world learned to its chagrin in 2007–2008, banks and other lenders are not
perfect screeners. Sometimes, under competitive pressure, they lend to borrowers
they should not have. Sometimes, individual bankers profit handsomely by lending to
very risky borrowers, even though their actions endanger their banks’ very existence.
Other times, external political or societal pressures induce bankers to make loans
they normally wouldn’t. Such excesses are always reversed eventually because the
lenders suffer from high levels of nonperforming loans.

Stop and Think Box

In the first quarter of 2007, banks and other intermediaries specializing in

originating home mortgages (called mortgage companies) experienced a major
setback in the so-called subprime market, the segment of the market that caters to
high-risk borrowers, because default rates soared much higher than expected. Losses
were so extensive that many people feared, correctly as it turned out, that they could
trigger a financial crisis. To stave off such a potentially dangerous outcome, why
didn’t the government immediately intervene by guaranteeing the subprime
mortgages?

The government must be careful to try to support the financial system without giving
succor to those who have screwed up. Directly bailing out the subprime lenders by
guaranteeing mortgage payments would cause moral hazard to skyrocket, it realized.
Borrowers might be more likely to default by rationalizing that the crime is a
victimless one (though, in fact, all taxpayers would suffer—recall that there is no such
thing as a free lunch in economics). Lenders would learn that they can make crazy
loans to anyone because good ol’ Uncle Sam will cushion, or even prevent, their fall.

KEY TA KEA WA YS
 Credit risk is the chance that a borrower will default on a loan by not fully
meeting stipulated payments on time.
 Bankers manage credit risk by screening applicants (taking applications and
verifying the information they contain), monitoring loan recipients, requiring
collateral like real estate and compensatory balances, and including a variety of
restrictive covenants in loans.
 They also manage credit risk by trading off between the costs and benefits of
specialization and portfolio diversification.

9.5 Interest-Rate Risk
LEA RN IN G OBJ ECTIV E

1. What is interest rate risk and how do bankers manage it?

Financial intermediaries can also be brought low by changes in interest rates.

Consider the situation of Some Bank:

Some Bank (Billions USD)

Assets Liabilities
Interest-rate-sensitive assets like variable rate and Interest-rate-sensitive liabilities like
short-term loans and short-term securities $10 variable rate CDs and MMDAs $20
Fixed-rate assets like reserves, long-term loans and Fixed-rate liabilities like checkable
securities $50 deposits, CDs, equity capital $40

If interest rates increase, Some Bank’s gross profits, the difference between what it
pays for its liabilities and earns on its assets, will decline because the value of its rate-
sensitive liabilities exceeds that of its rate-sensitive assets (assuming the spread stays
the same). Say, for instance, it today pays 3 percent for its rate-sensitive liabilities
and receives 7 percent on its rate-sensitive assets. That means it is paying 20 × .03 =
$.6 billion to earn 10 × .06 = $.7 billion. (Not bad work if you can get it.) If interest
rates increase 1 percent on each side of the balance sheet, Some Bank will be paying
20 × .04 = $.8 billion to earn 10 × .08 = $.8 billion. (No profits there.) If rates
increase another 1 percent, it will have to pay 20 × .05 = $1 billion to earn 10 × .09 =
$.9 billion, a total loss of $.2 billion (from a $.1 billion profit to a $.1 billion loss).

Stop and Think Box

Inflation was unexpectedly high in the 1970s. Given what you learned about the
relationship between inflation and nominal interest rates in Chapter 5 "The
Economics of Interest-Rate Fluctuations", and between interest rates and bank
profitability in this chapter, what happened in the 1980s?

Bank profitability sank to the point that many banks, the infamous savings and loans
(S&Ls), went under. Inflation (via the Fisher Equation) caused nominal interest rates
to increase, which hurt banks’ profitability because they were earning low rates on
long-term assets (like thirty-year bonds) while having to pay high rates on their
short-term liabilities. Mounting losses induced many bankers to take on added risks,
including risks in the derivatives markets. A few restored their banks to profitability,
but others destroyed all of their bank’s capital and then some.

Of course, if the value of its risk-sensitive assets exceeded that of its liabilities, the
bank would profit from interest rate increases. It would suffer, though, if interest
rates decreased. Imagine Some Bank has $10 billion in interest rate-sensitive assets
at 8 percent and only $1 billion in interest rate-sensitive liabilities at 5 percent. It is
earning 10 × .08 = $.8 billion while paying 1 × .05 = $.05 billion. If interest rates
decreased, it might earn only 10 × .05 = $.5 billion while paying 1 × .02 = $.02
billion; thus, ceteris paribus, its gross profits would decline from .8 − .05 = $.75
billion to .5 − .02 = $.48 billion, a loss of $.27 billion. More formally, this type of
calculation, called basic gap analysis, is

C ρ   =   ( A r - L r )   ×   △ i

where:

Cρ = changes in profitability

Ar = risk-sensitive assets
Lr = risk-sensitive liabilities

Δi = change in interest rates

So, returning to our first example,

C ρ = ( 10 - 20 )   ×   .02 = - 10   ×   .02 = - $ .2  billion ,

and the example above,

C ρ = ( 10 - 1 )   -   ( - .03 ) = - $ .27  billion .

Complete the exercise to get comfortable conducting basic gap analysis.

EX ERCISE

Use the basic gap analysis formula to estimate Some Bank’s loss or gain under the
following scenarios.
C ρ = ( A r - L r )   ×   △ i
Risk Sensitive Assets Risk Sensitive Liabilities Change in Interest Answer:
(Millions USD) (Millions USD) Rates (%) CP (Millions USD)
100 100 100 0
100 200 10 −10
100 200 −10 10
199 200 10 −0.1
199 200 −10 0.1
200 100 10 10
200 100 −10 −10
200 199 10 0.1
200 199 −10 −0.1
1000 0 1 10
0 1000 1 −10

Now, take a look at Figure 9.3 "Basic gap analysis matrix", which summarizes, in a 2
× 2 matrix, what happens to bank profits when the gap is positive (Ar > Lr) or
negative (Ar < Lr) when interest rates fall or rise. Basically, bankers want to have
more interest-sensitive assets than liabilities if they think that interest rates are
likely to rise and they want to have more interest rate-sensitive liabilities than
assets if they think that interest rates are likely to decline.

Figure 9.3 Basic gap analysis matrix

Of course, not all rate-sensitive liabilities and assets have the same maturities, so to
assess their interest rate risk exposure bankers usually engage in more sophisticated
analyses like the maturity bucket approach, standardized gap analysis, or duration
analysis. Duration, also known as Macaulay’s Duration, measures the average length
of a security’s stream of
payments.http://www.riskglossary.com/link/duration_and_convexity.htm In this
context, duration is used to estimate the sensitivity of a security’s or a portfolio’s
market value to interest rate changes via this formula:

△ % P = - △ % i   ×   d

Δ%P = percentage change in market value

Δi = change in interest (not decimalized, i.e., represent 5% as 5, not .05. Also note the
negative sign. The sign is negative because, as we learned in Chapter 4 "Interest
Rates", interest rates and prices are inversely related.)

d = duration (years)

So, if interest rates increase 2 percent and the average duration of a bank’s $100
million of assets is 3 years, the value of those assets will fall approximately −2 × 3 =
−6%, or $6 million. If the value of that bank’s liabilities (excluding equity) is $95
million, and the duration is also 3 years, the value of the liabilities will also fall, 95 × .
06 = $5.7 million, effectively reducing the bank’s equity (6 − 5.7= ) $.3 million. If the
duration of the bank’s liabilities is only 1 year, then its liabilities will fall −2 × 1 = −2%
or 95 × .02 = $1.9 million, and the bank will suffer an even larger loss (6 − 1.9 =) of
$4.1 million. If, on the other hand, the duration of the bank’s liabilities is 10 years, its
liabilities will decrease −2 × 10 = −20% or $19 million and the bank will profit from
the interest rate rise.

A basic interest rate risk reduction strategy when interest rates are expected to fall is
to keep the duration of liabilities short and the duration of assets long. That way, the
bank continues to earn the old, higher rate on its assets but benefits from the new
lower rates on its deposits, CDs, and other liabilities. As noted above, borrowing
short and lending long is second nature for banks, which tend to thrive when
interest rates go down. When interest rates increase, banks would like to keep the
duration of assets short and the duration of liabilities long. That way, the bank earns
the new, higher rate on its assets and keeps its liabilities locked in at the older, lower
rates. But banks can only go so far in this direction because it runs against their
nature; few people want to borrow if the loans are callable and fewer still want long-
term checkable deposits!

KEY TA KEA WA YS

 Interest rate risk is the chance that interest rates may increase, decreasing the
value of bank assets.
 Bankers manage interest rate risk by performing analyses like basic gap analysis,
which compares a bank’s interest rate risk-sensitive assets and liabilities, and duration
analysis, which accounts for the fact that bank assets and liabilities have different
maturities.
 Such analyses, combined with interest rate predictions, tell bankers when to
increase or decrease their rate-sensitive assets or liabilities, and whether to shorten
or lengthen the duration of their assets or liabilities.
 Bankers can also hedge against interest rate risk by trading derivatives, like swaps
and futures, and engaging in other off-balance-sheet activities.

9.6 Off the Balance Sheet

LEA RN IN G OBJ ECTIV E

1. What are off-balance-sheet activities and why do bankers engage in them?

To protect themselves against interest rate increases, banks go off road, engaging
in activities that do not appear on their balance sheets.This is not to say that these
activities are not accounted for. It isn’t illegal or even slimy. These activities will
appear on revenue statements, cash flow analyses, etc. They do not, however, appear
on the balance sheet, on the list of the bank’s assets and liabilities.Banks charge
customers all sorts of fees, and not just the little ones that they sometimes slap on
retail checking depositors. They also charge fees for loan guarantees, backup lines of
credit, and foreign exchange transactions. Banks also now sell some of their loans to
investors. Banks usually make about .15 percent when they sell a loan, which can be
thought of as their fee for originating the loan, for, in other words, finding and
screening the borrower. So, for example, a bank might discount the $100,000 note of
XYZ Corp. for 1 year at 8 percent. We know from the present value formula that on
the day it is made, said loan is worth PV = FV/(1 + i) = 100,000/1.08 = $92,592.59.
The bank might sell it for 100,000/1.0785 = $92,721.37 and pocket the difference.
Such activities are not without risks, however. Loan guarantees can become very
costly if the guaranteed party defaults. Similarly, banks often sell loans with a
guarantee or stipulation that they will buy them back if the borrower defaults. (If they
didn’t do so, as noted above, investors would not pay much for them because they
would fear adverse selection, that is, the bank pawning off their worse loans on
unsuspecting third parties.) Although loans and fees can help keep up bank revenues
and profits in the face of rising interest rates, they do not absolve the bank of the
necessity of carefully managing its credit risks.

Banks (and other financial intermediaries) also take off-balance-sheet positions in

derivatives markets, including futures and interest rate swaps. They sometimes use
derivatives to hedge their risks; that is, they try to earn income should the bank’s
main business suffer a decline if, say, interest rates rise. For example, bankers sell
futures contracts on U.S. Treasuries at the Chicago Board of Trade. If interest rates
increase, the price of bonds, we know, will decrease. The bank can then effectively
buy bonds in the open market at less than the contract price, make good on the
contract, and pocket the difference, helping to offset the damage the interest rate
increase will cause the bank’s balance sheet.
Bankers can also hedge their bank’s interest rate risk by engaging in interest rate
swaps. A bank might agree to pay a finance company a fixed 6 percent on a $100
million notational principle (or $6 million) every year for ten years in exchange for
the finance company’s promise to pay to the bank a market rate like the federal funds
rate or London Interbank Offering Rate (LIBOR) plus 3 percent. If the market rate
increases from 3 percent (which initially would entail a wash because 6 fixed = 3
LIBOR plus 3 contractual) to 5 percent, the finance company will pay the net due to
the bank, (3 + 5 = 8 − 6 = 2% on $100 million =) $2 million, which the bank can use
to cover the damage to its balance sheet brought about by the higher rates. If interest
rates later fall to 2 percent, the bank will have to start paying the finance company (6
− [3 + 2] = 1% on $100 million) $1 million per year but will well be able to afford it.

Banks and other financial intermediaries also sometimes speculate in derivatives

and the foreign exchange markets, hoping to make a big killing. Of course, with the
potential for high returns comes high levels of risk. Several hoary banks have gone
bankrupt because they assumed too much off-balance-sheet risk. In some cases, the
failures were due to the principal-agent problem: rogue traders bet their jobs, and
their banks, and lost. In other cases, traders were mere scapegoats, instructed to
behave as they did by the bank’s managers or owners. In either case, it is difficult to
have much sympathy for the bankers, who were either deliberate risk-takers or
incompetent. There are some very basic internal controls that can prevent traders
from risking too much of the capital of the banks they trade for, as well as techniques,
called value at riskhttp://www.gloriamundi.org/ and stress testing,http://financial-
dictionary.thefreedictionary.com/Stress+Testing that allow bankers to assess their
bank’s derivative risk exposure.

KEY TA KEA WA YS

 Off-balance-sheet activities like fees, loan sales, and derivatives trading help
banks to manage their interest rate risk by providing them with income that is not
based on assets (and hence is off the balance sheet).
 Derivatives trading can be used to hedge or reduce interest rate risks but can also
be used by risky bankers or rogue traders to increase risk to the point of endangering
a bank’s capital cushion and hence its economic existence.

2204
Budgets, Budgets, and More Budgets
by Kerri Schaffert (Instructor) - Wednesday, 2 September 2020, 5:09 PM
Number of replies: 1
Review the material in Chapter 5 on "Financial Plans: Budgets." Discuss one of the following in at least 100
words.

 What are the causes of budget variances?

OR
 Jake has discovered a large budget variance in his gas (fuel) expenses. What can he do about it?
OR
 Willow’s annual budget is in disarray because of unexpected variances, some of which are not in her
control. She was not expecting a 10% rent increase, which increased her expenditures, nor a 15% increase in
contributions to her employer’s health insurance plan, which reduced her income. In addition, her savings
lost future value when her bank reduced its interest rate by 2.5%. At the same time, she spent more on
clothing, entertainment, and gifts than she realized—more than she had budgeted for. Willow is
discouraged. What should she do?

2
Written Assignment Unit 4
Prepare an essay approximately 500-650 words that answers all three elements below. Cite references to material
that you use in preparing the essay.

a. What financial tools described in this chapter can help you make better financial decisions?

b. What are the components of a comprehensive budget and what is the purpose of each component?

c. How are specialized budgets prepared? What is the relationship of specialized budgets to the comprehensive
budget?
3
Learning Journal Unit 4
When is a cash flow budget a useful alternative to a comprehensive budget? Answer in approximately 250
words.