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GLENN
O’BRIEN
Money,
Banking, and
the Financial System
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Bank capital The difference between the value of a bank’s assets and the
value of its liabilities; also called shareholders’ equity.
Checkable Deposits
Checkable deposits Accounts against which depositors can write checks, also
called transaction deposits.
Reserves A bank asset consisting of vault cash plus bank deposits with the
Federal Reserve.
Vault cash Cash on hand in a bank; includes currency in ATMs and deposits
with other banks.
Excess reserves Any reserves banks hold above those necessary to meet
reserve requirements.
• Bank capital, also called shareholders’ equity, or bank net worth, is the
difference between the value of a bank’s assets and the value of its
liabilities.
• In 2010, for the U.S. banking system as a whole, bank capital was about
12% of bank assets.
• A bank’s capital equals the funds contributed by the bank’s shareholders
through their purchases of stock the bank has issued plus accumulated
retained profits.
• Note that as the value of a bank’s assets or liabilities changes, so does the
value of the bank’s capital.
a. Use the entries to construct a balance sheet similar to the one in Table 10.1,
with assets on the left side of the balance sheet and liabilities and bank
capital on the right side.
b. The bank’s capital is what percentage of its assets?
The Basics of Commercial Banking: The Bank Balance Sheet
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 20 of 55
Solved Problem 10.1
Constructing a Bank Balance Sheet
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by using the entries to construct the bank’s balance
sheet, remembering that bank capital is equal to the value of assets
minus the value of liabilities.
In this example, Wells Fargo uses its excess reserves to buy Treasury bills
worth $30 and make a loan worth $60.
The Basic Operations of a Commercial Bank
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Making the Connection
The Not-So-Simple Relationship between Loan Losses and Bank Profits
• During the term of the loan, if the bank decides that the borrower is likely to
default, the bank must write down or write off the loan.
• Banks set aside part of their capital as a loan loss reserve to anticipate
future loan losses and avoid large swings in its reported profits and capital
from write-offs.
• During the financial crisis of 2007–2009, banks set aside enormous loan loss
reserves as they anticipated write-downs on mortgage-related loans.
• The SEC has argued that banks will sometimes increase their loan loss
reserves more than is justified during an economic expansion, when defaults
are relatively rare. The banks can then draw down the reserves during a
recession, evening out their reported profits.
• If true, this practice would amount to “earnings management,” which is
prohibited under accounting rules because it may give a misleading view of
the firm’s profits.
Net interest margin The difference between the interest a bank receives on its
securities and loans and the interest it pays on deposits and debt, divided by
the total value of its earning assets.
• An expression for the bank’s total profits earned per dollar of assets is called
return on assets.
Return on assets (ROA) The ratio of the value of a bank’s after-tax profit to
the value of its assets.
After−tax profit
ROA =
Bank assets
Return on equity (ROE) The ratio of the value of a bank’s after-tax profit to the
value of its capital.
After−tax profit
ROE =
Bank capital
• ROA and ROE are related by the ratio of a bank’s assets to its capital:
Bank assets
ROE = ROA ×
Bank capital
Bank leverage The ratio of the value of a bank’s assets to the value of its
capital, the inverse of which (capital to assets) is called a bank’s leverage
ratio.
Liquidity risk The possibility that a bank may not be able to meet its cash
needs by selling assets or raising funds at a reasonable cost.
Diversification
• By diversifying, banks can reduce the credit risk associated with lending too
much to a single borrower, region, or industry.
Credit-Risk Analysis
Credit-risk analysis The process that bank loan officers use to screen loan
applicants.
Prime rate Formerly, the interest rate banks charged on six-month loans to
high-quality borrowers; currently, an interest rate banks charge primarily to
smaller borrowers.
Managing Bank Risk
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Collateral
• Collateral, or assets pledged to the bank in the event that the borrower
defaults, is used to reduce adverse selection.
• A compensating balance is a required minimum amount that the business
taking out the loan must maintain in a checking account with the lending
bank.
Credit Rationing
Credit rationing The restriction of credit by lenders such that borrowers cannot
obtain the funds they desire at the given interest rate.
• Loan and credit limits reduce moral hazard by increasing the chance a
borrower will repay.
• If the bank cannot distinguish the low- from the high-risk borrowers, high
interest rates risk dropping the low-risk borrowers out of the loan pool,
leaving only the high-risk borrowers—a case of adverse selection.
Managing Bank Risk
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Monitoring and Restrictive Covenants
• Banks keep track of whether borrowers are obeying restrictive
covenants, or explicit provisions in the loan agreement that prohibit the
borrower from engaging in certain activities.
A rise (fall) in the market interest rate will lower (increase) the present value
of a bank’s assets and liabilities.
Gap analysis An analysis of the difference, or gap, between the dollar value of
a bank’s variable-rate assets and the dollar value of its variable-rate liabilities.
• If a bank has a positive duration gap, the duration of the bank’s assets is
greater than the duration of the bank’s liabilities. In this case, an increase in
market interest rates will reduce the value of the bank’s assets more than
the value of the bank’s liabilities, which will decrease the bank’s capital.
The National Banking Act of 1863 made it possible for a bank to obtain a
federal charter.
Dual banking system The system in the United States in which banks are
chartered by either a state government or the federal government.
• In the early 1900s, banks were prohibited from crossing state lines.
Unit banking meant that banks were kept small, serving the local area.
• In 1900, of the 12,427 commercial banks in the United States, only 87
had any branches.
• The U.S. system of many small, geographically limited banks failed to
take advantage of economies of scale in banking.
• Restrictions on branching within the state loosened after the mid-
1970s, and in 1994, Congress passed the Riegle-Neal Interstate
Banking and Branching Efficiency Act, which allowed for the phased
removal of restrictions on interstate banking.
• These changes led to rapid consolidation of banks, from 14,384 in
1975 to only 6,839 by 2009. In 2010, concerns about bank size and
banks “too big to fail” were discussed in Congress, but no limits on size
were finally enacted.
Trends in the U.S. Commercial Banking Industry
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Trends in the U.S. Commercial Banking Industry
© 2012 Pearson Education, Inc. Publishing as Prentice Hall 44 of 55
Expanding the Boundaries of Banking
• Between 1960 and 2010, banks increased their funds and borrowings; they
relied less on C&I and consumer loans, and more on real estate loans; they
expanded into nontraditional lending activities and activities generating
revenue from fees instead of interest.
Off-Balance-Sheet Activities
2. Loan commitments.
Loan commitment An agreement by a bank to provide a borrower with a
stated amount of funds during some specified period of time.
4. Trading activities.
• Banks earn fees from trading in the multibillion-dollar markets for futures,
options, and interest-rate swaps.
• Bank losses from trading in securities became a concern during the
financial crisis of 2007-2009.
Another initiative to inject capital into banks, called the Capital Purchase
Program (CPP), also relied on the U.S. Treasury to purchase stock in hundreds
of troubled banks.
Evidence of U.S. banks’ profits can be found in their balance sheets. Bank
capital as a percentage of assets was lower when interest rates were higher
prior to the financial crisis.