Learning Unit #17

Bank Operation Basics

Objectives of Learning Unit

Explore banking business through its balance sheet:– Bank balance sheet– Bank operation and T-account– Off-balance sheet activities

Balance Sheet

Balance sheet: A list of the assets and liabilities. Assets: What owned. Liabilities: What owed. What do you own? Cash, textbooks, car, etc.

What do you owe? Credit card loan, student loan, utility bill?

Bank Balance Sheet

Like any other organizations, bank’s balance sheet list all of its assets and liabilities and their (book) values.

Some asset and liability items are same as other organizations such as fixed assets (e.g. buildings and equipments) and note payables (e.g. bonds issued by banks).

Banks have very different items on their note receivables (on their assets side) and account payables (on their liabilities side), which business students, in particular accounting majors, should not confuse!

Bank Assets

Bank assets are what a bank owns or its claims for future payments.

Cash in vault Deposits at the Federal Reserve Bank Securities (e.g. Treasury bonds, municipal bonds) Loans (e.g. Consumer loans, mortgage loans, student

loans, commercial loans)– These items are considered liabilities for businesses and

households who get loans from banks, but assets (note receivable) for banks which make loans.

Fixed assets (e.g. Buildings, ATM machines)

Bank Liabilities and Owners’ Equity

Bank liabilities are what a bank owes. Deposits (e.g. checkable deposits, non-transaction

deposits – CDs)– These are considered as assets for households and

businesses who deposit funds at banks, but liabilities (account payable) for banks which borrows funds (called deposits) from them.

Borrowings include– Loans from other banks: Federal funds– Loans from the Fed: Discount loans– Long-term bonds that a bank issued

Bank’s owners’ equity is called “capital” or “net worth”– Owners’ equity is the difference between total assets and total

liabilities.

Federal Reserve Bank as Bank for Banks

The Federal Reserve not only serves as the monetary authority in the U.S. to conduct the monetary policy, but also functions as the bank for all banks in the U.S.

Like any bank, the Fed accepts deposits from banks.– The Fed uses banks’ accounts to make settlements among

them (like checking accounts). Like any bank, the Fed provides loans (discount

loans) to banks.– The Fed charges an interest on its discount loans (discount

rate)

Settlements at the Fed Ron purchases Xbox 360 at Wal-Mart and pays by a check, where Wal-Mart has its

account at Wachovia Bank and Ron has his account at Bank of America. Wal-Mart deposits Ron’s check at Wachovia Bank, which sends it to the Fed. The

Fed debits Bank-of-America account and credits Wachovia-Bank account by $299. Wachovia Bank credits Wal-Mart account by $299, while Bank of America debits

Ron’s account by $299. The Fed uses Wachovia-Bank and Bank-of-America accounts at the Fed to settle

rather than shipping cash from Bank-of-America to Wachovia Bank.

Wal-Mart Ron$299

Check

Wachovia Bank

Bank of America

Fed

Reserves Sum of Vault cash and deposits at the Fed is called

“Reserves.” Reserves are important for banks, since they are

extremely liquid and are used to pay back to depositors whenever they withdraw funds.

Required Reserves: The Fed requires banks to keep a certain fraction (required reserve ratio) of deposits at banks.

Excess Reserves: Any extra reserves held by a bank beyond the required reserves.

The original idea of reserves is to ensure each bank to hold enough cash to meet depositors’ withdrawals, but now required reserves are used to control the money supply (for conduct of monetary policy).

The Fed pays interest on required and excess reserves.

Required Reserves: Example

Bank of America has $100 million of deposits and holds $15 million of reserves. A required reserve ratio is 10%.

Required reserves are 10% of $100 million deposits, that is $10 million.

Excess reserves are any reserves held by Bank of America over its required reserves, that is $5 million (= $15 million - $10 million).

Bank Balance Sheet in U.S.

As of June 2011

Simplified Bank Balance Sheet

The balance sheet in the previous slide lists major assets and liabilities items that a typical commercial bank in the U.S. holds.

However, for simplicity of analysis, we only focus on the following items in this course.

ReservesSecuritiesLoans

DepositsBorrowingsCapital

Assets Liabilities &Owners’ Equity

Banking Operations

What does a bank do? It does not produce or sell anything.

Remember the chart of “Financial System” in Learning Unit 2? Banks simply borrow funds from someone who have excess funds and lend the funds to someone else who are short in funds. So, we call them “Financial intermediaries.”

We use T-accounts to see how a bank operates its basic banking business: first borrow, then lend.

T-account

T-account shows a change in items on the balance sheet.– Changes in asset items are shown on the left side,

while changes in liability items are shown on the right side.

– An increase in item is indicated as “+” sign, while a decrease in item is indicated as “-” sign.

Important! T-account system used in this course is different from T-account used in Accounting. Don’t be confused.

Basic Bank Operation: Deposit

Example: Tiffany deposits $100 cash at Bank of America.

This transaction affects the balance sheet of Bank of America.– Bank of America has $100 additional cash in its vault.

Its reserves increase by $100.– Bank of America owes $100 to Tiffany.

Its deposits increase by $100.

Deposits Operation in T-Account

This transaction can be shown in one simple T-account.

Since deposits are liabilities item, it is shown as an increase of $100 on the liabilities side.

Since cash is a part of reserves, an additional cash is shown as an increase of reserves by $100 on the assets side.

Both assets and liabilities increase by $100, so the bank’s balance sheet still balances!

Reserves +$100 Deposits +100BankAmerica

Changes in Deposits and Reserves

When a bank receives deposits, it gains an equal amount of reserves.

When it loses deposits (depositors withdraw funds), it loses an equal amount of reserves.

If Tiffany withdraws $100 from Bank of America,

Reserves -$100 Deposits -100BankAmerica

Basic of Bank Operation: Required Reserves

A required reserve ratio is 10%. With $100 deposit by Tiffany, Bank of America

must maintain additional required reserves of $10 (= $100 of additional deposits x 10% required reserve ratio).

This will leave additional $90 excess reserves (= $100 additional reserves - $10 additional required reserves).

What will Bank of America do with this extra funds? Of course, loan it out!

Basic of Bank Operation: Loan

Eric wants to borrow $90 from bank of America to purchase a textbook.

Eric fills his loan application, signs it, and receives $90 cash from a loan officer at Bank of America.– Bank of America has $90 less cash.

Its reserves decrease by $90.– Eric promises to pay back $90 later, so Bank of

America has additional $90 loan contract (note payable).

Its loans increase by $90.

Loan Operation in T-Account

Since both reserves and loans are assets items, their changes are shown on the left side of T-account.

Net change in assets items is $0 (= -$90 of reserves +$90 of loans), while there is no change in liabilities.

Since both sides of T-account do not change in net, the bank’s balance sheet still balances!

Reserves -$90Loans +$90

BankAmerica

Consolidate Bank Operations

In the previous slides, you see two basic operations of bank’s business: deposit and loan. Here, two transactions are combined to see overall effects of the basic banking operations on bank’s balance sheet by combining two T-accounts.

On the first transaction, both deposits (on liabilities side) and reserves (on assets side) increase by $100.

On the second transaction, reserves (on assets side) decrease by $90 and loans (on assets side) increase by $90.

Changes in reserves in two transactions partly offset each others, leaving an increase of reserves by $10.

Consolidate T-Account

The consolidated T-account shows– Bank of America received $100 funds in form of

deposits, then– Bank of America keeps $10 reserves as required

and uses $90 to make a loan.

Reserves +$10Loans +$90

BankAmericaDeposits +$100

Sources and Uses of Funds

Bank balance sheet shows where a bank gets funds and where the bank uses that funds for its banking business.

Sources of funds: items on the liabilities side show where a bank gets funds for its business.– Deposits, Borrowings (funds borrowed from other

banks or the Fed), or Capital (funds contributed by shareholders)

Uses of funds: items on the assets side show where a bank uses funds for its business.– Reserves, loans (lend out to borrowers), securities

(purchased for investment)

Costs and Revenues of Bank

Bank balance sheet also shows where a bank earns revenues and where the bank incurs costs for its banking business.

Sources of funds incur costs of banking business:– Interest paid on deposits to depositors and on loans

borrowed from other banks or the Fed Uses of funds provide revenues of banking

business:– Interest earned on loans from borrowers and on

securities

Interest Rates, Revenue, and Cost

Example: Bank of America pays 3% interest rate on deposits and charges 20% interest rate on loans on two transactions earlier.

Revenues = $90 x 20% = $18– Note: Reserves do not earn any interest revenue.

Costs = $100 x 3% = $3

Reserves +$10Loans +$90

BankAmericaDeposits +$100

Profits of Banking Business

With 3% interest rate on deposits and 20% interest rate on loans, Bank of America will earn $15 gross profits on these transactions.

– Gross Profits = Revenues – Costs = $18 - $3

This profit does not include any costs of labor (teller salary) or capital (office equipments, office building), so net profit will be much smaller.

If Bank of America pays 20% interest rate on deposits, what will happen to its profits?

– Should a for-profit business firm like Bank of America give high or low interest rates on deposits? How about high or low interest rates on loans?

How Bank Make Profits

Banks charge high interest rates on loans and give low interest rates on deposits to make profits.

This difference in interest rates is considered as fee charged on services that the bank provides to its customers.

Interest Rates and Banking Services

Remember what affect an interest rate on an asset? Risk, liquidity, and maturity [See Learning unit 12 &13].

Banks can charge high interest rates on loans because loans are usually– Risky, illiquid, and long-term

Banks can pay low interest rates on deposits because deposits are usually– Safe, liquid, and short-term (on demand)

Asset Transformation as Banking Service

Banking business involves asset transformation: They issue short-term liquid and safe financial instruments (deposits) to depositors and acquire long-term illiquid and risky financial instruments.

For savers, banks as financial intermediaries transform long-term illiquid risky loans issued by borrowers to short-term liquid safe deposits.

– In addition, banks provide information services (remember three financial services?) that they find best borrowers for depositors’ funds.

– Depositors accept low interest rates on their deposits in order to receive these services. If not, they can lend their funds directly to any borrowers and charge 20% interest rate? Will you?

Off-Balance-Sheet Activities

Bank’s balance sheet shows how a bank generate revenues, incurs costs, and earns profits.

There are some banking activities which are not visible on its balance sheet, but affect bank’s profits.

Off-balance-sheet activities: Bank activities that affect bank profits but are not visible on bank balance sheet.

– Loan sales– Fee income– Trading activities and risk management techniques

Loan Sales

Traditionally, when a bank makes loans, most likely the bank keeps them until their maturities.

Recently, many banks sell loans to the third party and earn instant profits (rather than waiting for their maturities to realize profits).

– Securitization [Learning unit #6]– Banks still collect payments from borrowers (or contract out

this activities to “servicer” firm), but simply send them to the third party which owns those loans.

Profits (or losses) on loan sales are not visible from bank’s balance sheet.

– In early 2000s many banks made significant profits from sub-prime mortgage loan sales.

– Loan sales also allow banks to pass any risk associated with loans to the third party.

Fee Incomes

Banks charge on many banking and related services.– Bounced check fee– Minimum balance fee or account maintenance fee– Late payment fee– ATM user fee– Safe deposit fee– Notarization fee– Loan origination or processing fee– Annual membership fee (on credit cards)– In 2005, Bank of America even tried to charge fees to

customers who use a teller rather than ATM machine.

Trading Activities & Risk Management

Banks engage in derivative trading for hedging.– On the balance sheet, derivatives are not seen as

large as actual obligations, since only a fraction of actual obligations is usually shown on its balance sheet.

– Derivatives can bring more profits to banks by engaging in speculation as well as potentially huge losses if they are not used properly.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University