Economics 330 Fall 2006, lecture of 25 October 2006
Basic Banking—Cash Deposit
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100
Cash deposits deposits
• Opening of a checking account leads to an
increase in the bank’s reserves equal to the
increase in checkable deposits
Basic Banking—Check
Deposit
When a bank receives
First National Bank
additional deposits, it
Assets Liabilities
gains an equal amount of reserves;
Cash items +$100 Checkable +$100
in process deposits when it loses deposits,
of collection it loses an equal amount of reserves
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100
deposits deposits
Basic Banking—Making a
Profit
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Required +$10 Checkable +$100 Required +$10 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves
• Asset transformation-selling liabilities with one set of
characteristics and using the proceeds to buy assets
with a different set of characteristics
• The bank borrows short and lends long
Bank Management
• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Interest-rate Risk
Liquidity Management:
Shortfall in Reserves
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M
• Reserves are a legal requirement and the
shortfall must be eliminated
• Excess reserves are insurance against the costs
associated with deposit outflows
Liquidity Management:
Borrowing
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
• Cost incurred is the interest rate paid on the
borrowed funds
Liquidity Management:
Securities Sale
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M
• The cost of selling securities is the brokerage
and other transaction costs
Liquidity Management: Reduce
Loans
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M
• Reduction of loans is the most costly way of
acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a
substantial discount
Capital Adequacy Management:
Preventing Bank Failure When
Assets Decline
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
Capital Adequacy Management:
Returns
Return on Assets:to Equity
net profit after taxes perHolders
dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
equity capital assets equity capital
ROE = ROA EM
Interest-Rate Risk
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
• If a bank has more rate-sensitive liabilities than assets, a rise in
interest rates will reduce bank profits and a decline in interest
rates will raise bank profits
Interest Rate Risk: Gap
Analysis
Basic Gap Analysis:
(rate-sensitive assets rate sensitive liabilities)
interest rates = in bank profits
Maturity Bucket Approach
measures the gap for several maturity subintervals
Standardized Gap Analysis
accounts for differing degrees of rate sensitivity
