bank balance sheet_ assets, liabilities, and bank capital

8/17/2019 Bank Balance Sheet_ Assets, Liabilities, And Bank Capital

1/5

1/18/2016 Bank Balance Sheet: Assets, Liabilities, and Bank Capital

http://thismatter.com/money/banking/bank-balance-sheet.htm

Bank Balance Sheet: Assets, Liabilities, and Bank Capital

A balance sheet (aka statement of condition, statement of financial position) isa financial report that shows the value of a company's assets, liabilities, and owner's equity at a specific period of time, usually at the end of an accounting period, such as a quarter or a year. An asset isanything that can be sold for value. A liability is an obligation that must eventually be paid, and, hence, itis a claim on assets. The owner's equity in a bank is often referred to as bank capital, which is what is

left when all assets have been sold and all liabilities have been paid. The relationship of the assets, liabilities,and owner's equity of a bank is shown by the following equation:

Bank Asse ts = Bank Liabilities + Bank Capital

A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as deposits or borrowings, to finance assets, such as loans to individuals or businesses, or to buy interest earning securities,the owners of the bank can leverage their bank capital to earn much more than would otherwise be possibleusing only the bank's capital.

Assets and liabilities are further distinguished as being either current or long-term. Current assets areassets expected to be sold or otherwise converted to cash within 1 year; otherwise, the assets are long-term

(aka noncurrent assets). Current liabilities are expected to be paid within 1 year; otherwise,the liabilities are long-term (aka noncurrent liabilities). Working capital is the excess of currentassets over current liabilities, a measure of its liquidity, meaning its ability to meet short-term liabilities:

Working Capital = Current Assets – Current Liabilities

Generally, working capital should be sufficient to meet current liabilities. However, it should not beexcessive, since capital in the form of long-term assets usually has a higher return. The excess of the bank'slong-term assets over its long-term liabilities is an indication of its solvency, its ability to continue as agoing concern.

Assets: Uses of Funds

Assets earn revenue for the bank and includes cash, securities, loans, and property and equipment thatallows it to operate.

Cash and Cash Equivalents

One of the major services of a bank is to supply cash on demand, whether it is a depositor withdrawingmoney or writing a check, or a bank customer drawing on a credit line. A bank also needs funds to pay bills, but while bills are predictable in both amount and timing, cash withdrawals by customers are not.

Hence, a bank must maintain a certain level of cash compared to its liabilities to maintain solvency. A bank must hold some cash as reserves, which is the amount of money held in a bank's account at the FederalReserve (Fed). The Federal Reserve determines the legal reserves, which is the minimum amount of cash that banks must hold in their accounts to ensure the safety of banks and also allows the Fed to effectmonetary policy by adjusting the reserve level. Often, banks will keep excess reserves for greater safety.

To do business at its branches and automated teller machines (ATMs), a bank also needs vault cash,which includes not only cash in its vaults, but also cash elsewhere on a bank's premises, such as in teller drawers, and the cash in its ATM machines.

Some banks, usually smaller banks, also have accounts at larger banks, called correspondentbanks. which are usually larger banks that often borrow from the smaller banks or perform services for

http://thismatter.com/money/banking/federal-reserve-monetary-policy-tools.htmhttp://thismatter.com/money/banking/bank-regulations-supervision.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/liquidity-measures.htmhttp://thismatter.com/money/banking/federal-reserve-monetary-policy-tools.htmhttp://thismatter.com/money/banking/bank-regulations-supervision.htmhttp://thismatter.com/money/stocks/valuation/debt-ratios.htmhttp://thismatter.com/money/stocks/valuation/liquidity-measures.htm


2/5



them. This relationship makes lending expeditious because many of these smaller banks are rural and haveexcess reserves whereas the larger banks in the cities usually have a deficiency of reserves.

Another source of cash is cash in the process of collection. When a banks receives a check, itmust present the check to the bank on which it is drawn for payment, and, previously, this has taken severaldays. Nowadays, checks are being processed electronically and many transfers of funds are beingconducted electronically instead of using checks. So this category of cash is diminishing significantly, andwill probably disappear when all financial transactions finally become electronic.

Cash equivalents are another short-term asset, so-called because they are nearly equivalent to cash:short-term investments that can either be used as cash or can be quickly converted to cash without loss of value, such as demand deposits, T-bills, and commercial paper . A primary characteristic of financialinstruments that are classified as cash equivalents is that they have a short-term maturity of 3 months or less, so interest rate risk is minimal, and they are the most highly rated securities or issued by a governmentthat can print its own money, such as the T-bills issued by the US government, so there is little credit risk.

Securities

The primary securities that banks own are United States Treasuries and municipal bonds. These bonds can be sold quickly in the secondary market when a bank needs more cash, so they are often referred to assecondary reserves.

The recent credit crisis has also underscored the fact that banks held many asset-backed securities as well.United States banks are not permitted to own stocks, because of the risk, but, ironically, they can hold muchriskier securities called derivatives.

Loans

Loans are the major asset for most banks. They earn more interest than banks have to pay on deposits, and,thus, are a major source of revenue for a bank. Often banks will sell the loans, such as mortgages, creditcard and auto loan receivables, to be securitized into asset-backed securities which can be sold to investors.This allows banks to make more loans while also earning origination fees and/or servicing fees on thesecuritized loans.

Loans include the following major types:

business loans, usually called commercial and industrial (C&I) loansreal estate loans

residential mortgageshome equity loanscommercial mortgages

consumer loans

credit cards

auto loans

interbank loans

Liabilities: Sources of Funds

Liabilities are either the deposits of customers or money that banks borrow from other sources to use tofund assets that earn revenue. Deposits are like debt in that it is money that the banks owe to the customer but they differ from debt in that the addition or withdrawal of money is at the discretion of the depositor rather than dictated by contract.

Checkable Deposits

http://thismatter.com/money/bonds/types/abs/auto-abs.htmhttp://thismatter.com/money/bonds/types/abs/credit-card-abs.htmhttp://thismatter.com/money/bonds/types/mortgage-backed-securities-mbs.htmhttp://thismatter.com/money/derivatives/derivatives.htmhttp://thismatter.com/money/stocks/stocks.htmhttp://thismatter.com/money/bonds/types/abs/asset-backed-securities.htmhttp://thismatter.com/money/bonds/types/government/municipal-bonds.htmhttp://thismatter.com/money/bonds/types/government/treasury-securities.htmhttp://thismatter.com/money/bonds/types/government/treasury-securities.htmhttp://thismatter.com/money/bonds/interest-rate-risk.htmhttp://thismatter.com/money/banking/financial-instruments.htmhttp://thismatter.com/money/bonds/types/money-market-instruments/commercial-paper.htm


3/5



Checkable deposits are deposits where depositors can withdraw the money at will. These includeall checking accounts. Some checkable deposits, such as NOW, super-NOW, and money market accounts pay interest, but most checking accounts pay very little or no interest. Instead, depositors use checkingaccounts for payment services, which, nowadays, also includes electronic banking services.

Before the 1980s, checkable deposits were a major source of cheap funds for banks, because they paid littleor no interest on the money. But as it became easier to transfer money between accounts, people started putting their money into higher yielding accounts and investments, transferring the money when they needed

it.

Nontransaction Deposits

Nontransaction deposits include savings accounts and time deposits, which are basically certificates of deposits (CDs). Savings accounts are not used as a payment system, which is whythey are categorized as nontransaction deposits and is also the reason why they pay more interest. Savingsdeposits of yore were mostly passbook savings accounts, where all transactions were recordedin a passbook. Nowadays, technology and regulations have allowed statement savings wheretransactions are recorded electronically and may be viewed by the depositor on the bank's website or amonthly statement is mailed to the depositor; and money market accounts, which have limitedcheck writing privileges and earn more interest than either checking or savings accounts.

A Certificate of Deposit (CD) is a time deposit where the depositor agrees to keep the money inthe account until the CD expires. The bank compensates the depositor with a higher interest rate. Althoughthe depositor can withdraw the money before the CD expires, banks charge a hefty fee for this.

There are 2 types of certificates of deposit (CDs): retail and large. A retail CD is for less than $100,000 andis generally sold to individuals. It cannot be resold easily. Large CDs are for $100,000 or more and arehighly negotiable so they can be easily resold in the money markets. Large negotiable CDs are a major source of funding for banks.

Nontransaction deposits in depository institutions are now insured to $250,000 by the Federal DepositInsurance Corporation (FDIC).

Borrowings

Banks also borrow money, usually from other banks in what is called the federal funds market, so-called because funds kept in their reserve accounts at the Federal Reserve are called federal funds, and it isthese accounts that are credited or debited as money is transferred between banks. Banks with excessreserves, which are usually smaller banks located in smaller communities, lend to the larger banks inmetropolitan areas, which are usually deficient in reserves.

The interbank loans in the federal funds market are unsecured, so banks only lend to other banks that theytrust. Part of the reason for the 2007 - 2009 Credit Crisis is that banks didn't know which other banks wereholding risky mortgage-backed securities that were beginning to default in large numbers, so they stopped

lending to each other, forcing banks to restrict their lending to the public, which caused the supply of moneyto decline and the economy to contract.

Banks also borrow from nondepository institutions, such as insurance companies and pension funds, butmost of these loans are collateralized in the form of a repurchase agreement <http://thismatter.com/money/bonds/typ es/money-market-instruments/repos.htm > (aka repo), where the bank gives thelender securities, usually Treasuries, as collateral for a short-term loan. Most repos are overnight loans thatare paid back with interest the very next day.

As a last resort banks can also borrow from the Federal Reserve (Fed), though they rarely do this since itindicates that they are under financial stress and unable to get funding elsewhere. However, during thecredit freeze in 2008 and 2009, many banks borrowed from the Fed because they could not get fundingelsewhere.

http://thismatter.com/money/bonds/types/money-market-instruments/repos.htmhttp://thismatter.com/money/banking/nondepository-institutions.htmhttp://thismatter.com/money/bonds/types/money-market-instruments/federal-funds.htmhttp://thismatter.com/money/banking/deposit-insurance.htmhttp://thismatter.com/money/banking/depository-institutions.htmhttp://thismatter.com/money/bonds/types/money-market-instruments.htmhttp://thismatter.com/money/bonds/types/money-market-instruments/certificates-of-deposit.htm


4/5



Bank Capital

Banks can also get more funds either from the bank's owners or, if it is a corporation, by issuing more stock .For instance, 19 of the largest banks that received federal bailout money during the credit crisis raised $43 billion of new capital in 2009 by issuing stock because their reserves were deemed inadequate in responseto stress testing by the United States Treasury.

Graph spanning 1990 - 2007 showing

how the number of banks hasdeclined continuously, and how theshare of all bank assets of the 10largest and 100 largest banks hasgrown in the same time period.

Source: Federal Reserve <

http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default.htm

>

New Accounting Rules for Valuing Assets

Bank capital (= total assets – total liabilities) is the bank's net worth. However, recent accountingchanges have made it more difficult to determine a bank's true net worth.

Banks were having a tough time in early 2009. The credit crisis has caused many defaults on mortgages,credit cards, and auto loans, forcing them to increase their loan loss reserves and to devalue many of theasset-backed securities that they held based on these loans. Consequently, banks were suffering major losses. A major contributor to these losses was because the asset-backed securities that were still held bythe banks had to be valued by mark-to-market rules, and since no one was buying these toxic securities,their mark-to-market value was very low.

To restore confidence in the banking system, the government allowed some changes to the accounting rulesthat artificially increased the revenues of the banks. The Financial Accounting Standards Board (FASB)allowed banks to value their assets according to fair value, as determined by the banks. Additionally, banks also didn't have to write down assets that they intended to keep to maturity. However, manycritics assert that there will be more defaults on the underlying loans of these securities, and, thus, will have

http://thismatter.com/money/bonds/types/abs/asset-backed-securities.htmhttp://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default.htmhttp://thismatter.com/money/stocks/stocks.htm


5/5



to be accounted for in the future.

Banks could also record income on their books if the market value of their debt declines. The reason for thisallowance is because they could buy back their own debt in the market, thus reducing their debt for afraction of its face value. However, critics have pointed out that if a bank doesn't have the money to buy back its debt, it could still record the reduced value as revenue even though the bank would have to pay the principal back when the debt matures.

Citigroup is a good example of how much the new accounting rules can change the income reported by a bank. According to this Bloomberg article < http://www.bloomberg.com/apps/news? pid=20601109&sid=alC3LxSjomZ8&refer=exclusive > , the $1.6 billion profit reported by Citigroup under the new

accounting rules for its 1s t quarter in 2009 would have been reduced to a $2.5 billion loss under the oldaccounting rules. Hence, Citigroup enjoyed a gain of $4.1 billion simply by changing the accounting rules!

Information is provided 'as is' and solely for education, not for trading purposes or professionaladvice.

Copyright © 1982 - 2016 by William C. Spaulding < http://thism atter.com/about.htm >
http://thismatter.com/about.htmhttp://www.bloomberg.com/apps/news?pid=20601109&sid=alC3LxSjomZ8&refer=exclusive

bank balance sheet_ assets, liabilities, and bank capital

Documents