Chapter Three

Banking and the Management of Financial institutions

Introduction
Banking plays a major role in channeling funds to borrowers with productive investment opportunities, this
financial activity is important in ensuring that the financial system and the economy run smoothly and
efficiently. They provide loans to businesses, help us finance our college educations or the purchase of a new
car or home, and provide us with services such as checking and savings accounts.
In this chapter, we examine how banking is conducted to earn the highest profits possible: how and why
banks make loans, how they acquire funds and manage their assets and liabilities (debts), and how they earn
income. Although we focus on commercial banking, because this is the most important financial
intermediary activity, many of the same principles are applicable to other types of financial intermediation.
3.1. The Bank Balance Sheet
The balance sheet of commercial banks can be thought of as a list of the sources and uses of bank funds. The
bank’s liabilities are its sources of funds, which include checkable deposits, time deposits, and discount loans
from the Fed, borrowings from other banks and corporations, and bank capital. The bank’s assets are its uses of
funds, which include reserves, cash items in process of collection, deposits at other banks, securities, loans, and
other assets (mostly physical capital).

Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, January 2003)
Assets (Uses of Funds)* Liabilities (Sources of Funds)
Reserves and cash items 5 Checkable deposits 9
Securities Non-transaction deposits
U.S. government and agency 15 Small-denomination time deposits
State and local government and (< $100,000) + savings deposits 42
other securities 10 Large-denomination time deposits 14
Loans Borrowings 28
Commercial and industrial 14 Bank capital 7
Real estate 29
Consumer 9
Interbank 4
Other 8
Other assets (for example,
physical capital) 6

Total 100 Total 100

*In order of decreasing liquidity.
To understand how banking works, first we need to examine the bank balance sheet, a list of the bank’s assets
and liabilities. As the name implies, this list balances; that is, it has the characteristic that:
total assets = total liabilities + capital
Furthermore, a bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they are put
(assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these
funds to acquire assets such as securities and loans. Banks make profits by charging an interest rate on their
holdings of securities and loans that is higher than the expenses on their liabilities. The balance sheet of all
commercial banks as of January 2003 appears in Table 1.
A bank acquires funds by issuing (selling) liabilities, which are consequently also referred to as sources of
funds. The funds obtained from issuing liabilities are used to purchase income-earning assets.
3.1.1. Commercial Banks liabilities
1. Checkable Deposits. Checkable deposits are bank accounts that allow the owner of the account to write
checks to third parties.
Checkable deposits include all accounts on which checks can be drawn: non-interest-bearing checking
accounts (demand deposits), interest-bearing NOW (negotiable order of withdrawal) accounts, and money
market deposit accounts (MMDAs).
Checkable deposits and money market deposit accounts are payable on demand; that is, if a depositor
shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor
immediately. Similarly, if a person, who receives a check written on an account from a bank, presents
that check at the bank, it must pay the funds out immediately (or credit them to that person’s account).
A checkable deposit is an asset for the depositor because it is part of his or her wealth. Conversely,
because the depositor can withdraw from an account funds that
2. Non-transaction Deposits. Non-transaction deposits are the primary source of bank funds (56% of bank
liabilities in Table 1). Owners cannot write checks on non-transaction deposits, but the interest rates are
usually higher than those on checkable deposits. There are two basic types of non-transaction deposits:
savings accounts and time deposits (also called certificates of deposit or CDs).
Savings accounts were once the most common type of non-transaction deposit. In these accounts, to which
funds can be added or from which funds can be withdrawn at any time, transactions and interest
payments are recorded in a monthly statement or in a small book (the passbook) held by the owner of
the account.
Time deposits have a fixed maturity length, ranging from several months to over five years, and have
substantial penalties for early withdrawal (the forfeiture of several months’ interest). Small-denomination
time deposits (deposits of less than $100,000) are less liquid for the depositor than passbook savings, earn
higher interest rates, and are a more costly source of funds for the banks.
3. Borrowings. Banks obtain funds by borrowing from the Federal Reserve System, the Federal Home Loan
banks, other banks, and corporations. Borrowings from the Fed are called discount loans (also known
as advances). Banks also borrow reserves overnight in the federal (fed) funds market from other U.S.
banks and financial institutions. Banks borrow funds overnight in order to have enough deposits at the
 Federal Reserve to meet the amount required by the Fed. (The federal funds designation is somewhat
confusing, because these loans are not made by the federal government or by the Federal Reserve, but
rather by banks to other banks.) Other sources of borrowed funds are loans made to banks by their
parent companies (bank holding companies), loan arrangements with corporations (such as repurchase
agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign
banks or foreign branches of U.S. banks). Borrowings have become a more important source of bank
funds over time: In 1960, they made up only 2% of bank liabilities; currently, they are 28% of bank
liabilities.
4. Bank Capital. The final category on the liabilities side of the balance sheet is bank capital, the bank’s net worth,
which equals the difference between total assets and liabilities. The funds are raised by selling new equity
(stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which
could force the bank into insolvency (having liabilities in excess of assets, meaning that the bank can be
forced into liquidation).
3.1.2. Commercial Banks Assets
A bank uses the funds that it has acquired by issuing liabilities to purchase income- earning assets. Bank assets
are thus naturally referred to as uses of funds, and the inter- est payments earned on them are what enable banks to
make profits.
1. Reserves. All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves
are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank
vaults overnight). Although reserves currently do not pay any interest, banks hold them for two reasons. First,
some reserves, called required reserves, are held because of reserve requirements, the regulation that for every
dollar of checkable deposits at a bank, a certain fraction (10 cents, for example) must be kept as reserves. This
fraction (10 percent in the exam- ple) is called the required reserve ratio. Banks hold additional reserves,
called excess reserves, because they are the most liquid of all bank assets and can be used by a bank to meet
its obligations when funds are withdrawn, either directly by a depositor or indirectly when a check is written
on an account.
2. Cash Items in Process of Collection. Suppose that a check written on an account at another bank is deposited
in your bank and the funds for this check have not yet been received (collected) from the other bank.
The check is classified as a cash item in process of collection, and it is an asset for your bank
because it is a claim on another bank for funds that will be paid within a few days.
3. Deposits at Other Banks. Many small banks hold deposits in larger banks in exchange for a variety of
services, including check collection, foreign exchange transactions, and help with securities
purchases. This is an aspect of a system called correspondent banking.
Collectively, reserves, cash items in process of collection and deposits at other banks are often
referred to as cash items. In Table 1, they constitute only 5% of total assets, and their importance has
been shrinking over time: In 1960, for example, they accounted for 20% of total assets.
4. Securities. A bank’s holdings of securities are an important income-earning asset: Securities (made up
entirely of debt instruments for commercial banks, because banks are not allowed to hold stock)
 account for 25% of bank assets in Table 1, and they provide commercial banks with about 10% of
their revenue. These securities can be classified into three categories: U.S. government and agency
securities, state and local government securities, and other securities. The United States government
and agency securities are the most liquid because they can be easily traded and converted into cash with
low transaction costs. Because of their high liquidity, short-term U.S. government securities are
called secondary reserves.
State and local government securities are desirable for banks to hold, primarily because state and
local governments are more likely to do business with banks that hold their securities. State and
local government and other securities are less marketable (hence less liquid) and are also riskier
than U.S. government securities, primarily because of default risk: There is some possibility that the
issuer of the securities may not be able to make its interest payments or pay back the face value of the
secu rities when they mature.
5. Loans. Banks make their profits primarily by issuing loans. In Table 1, some 64% of bank assets are in
the form of loans, and in recent years they have generally produced more than half of bank revenues. A
loan is a liability for the individual or corporation receiving it, but an asset for a bank, because it
provides income to the bank. Loans are typically less liquid than other assets, because they cannot be
turned into cash until the loan matures. If the bank makes a one-year loan, for example, it cannot get its
funds back until the loan comes due in one year. Loans also have a higher probability of default than
other assets. Because of the lack of liquidity and higher default risk, the bank earns its highest return
on loans.
As you saw in Table 1, the largest categories of loans for commercial banks are commercial and
industrial loans made to businesses and real estate loans. Commercial banks also make consumer loans and
lend to each other. The bulk of these interbank loans are overnight loans lent in the federal funds market.
The major difference in the balance sheets of the various depository institutions is primarily in the type of
loan in which they specialize. Savings and loans and mutual savings banks, for example, specialize in
residential mortgages, while credit unions tend to make consumer loans.
6. Other Assets. The physical capital (bank buildings, computers, and other equipment) owned by the banks
is included in this category.
3.2.General Principles of Bank Management
Now that you have some idea of how a bank operates, let’s look at how a bank man- ages its assets and
liabilities in order to earn the highest possible profit. The bank manager has four primary concerns. The
first is to make sure that the bank has enough ready cash to pay its depositors when there are deposit
outflows, that is, when deposits are lost because depositors make withdrawals and demand payment. To
keep enough cash on hand, the bank must engage in liquidity management, the acquisition of
sufficiently liquid assets to meet the bank’s obligations to depositors. Second, the bank manager must
pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by
diversifying asset holdings (asset management). The third concern is to acquire funds at low cost
(liability management). Finally, the manager must decide the amount of capital the bank should maintain
and then acquire the needed capital (capital adequacy management).
General Principles of BankManagement
A. Liquidity Management
 Liquidity management is a bank’s ability to fund assets and meet financial obligations without incurring
unacceptable financial costs. It is the role of the bank’s management team to ensure sufficient funds are
available to meet demands from both depositors and borrowers..
 Bank liquidity refers to the ability of the bank to ensure the availability of finds to meet financial
commitments or maturing obligations at a reasonable price at all times. Put tersely, bank liquidity means a
bank having money where they need it particularly to satisfy the withdrawal needs of the customers.
 Liquidity management refers to the planning and control necessary to ensure that the organization
maintains enough liquid assets either as an obligation to the customers of the organization so as to meet
some obligations incidental to survival of the business or as a measure to adhere to the monetary policies
of the central bank.

B. Asset Management

 Asset management is the practice of increasing total wealth over time by acquiring, maintaining, and
trading investments that have the potential to grow in value.

C. Liability Management

 Liability management is the practice by banks of maintaining a balance between the maturities of their
assets and their liabilities in order to maintain liquidity and to facilitate lending while also maintaining
healthy balance sheets.

D. Capital Adequacy Management

 Capital adequacy management is a bank’s decision about the amount of capital it should maintain and
then the acquisition of the needed capital.

 Capital adequacy management includes the decision regarding the amount of capital a bank ought to
hold and how it ought to be accessed.

E. Credit Risk

 Credit risk is the potential for a lender to lose money when they provide funds to a borrower.

 Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the
loan's conditions, and associated collateral.

 Consumers who are higher credit risks are charged higher interest rates on loans.

 Your credit score is one indicator that lenders use to assess how likely you are to default.

F. Interest-rate Risk

 Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond
or other fixed-rate investment:
 As interest rates rise bond prices fall, and vice versa. This means that the market price of existing
bonds drops to offset the more attractive rates of new bond issues.
 Interest rate risk is measured by a fixed income security's duration, with longer-term bonds having a
greater price sensitivity to rate changes.
 Interest rate risk can be reduced through diversification of bond maturities or hedged using interest
rate derivatives.