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8
The Economics of Banking
LEARNING OBJECTIVES
After studying this lesson, you should be able to:
8.1
8.2
8.3
8.4
C H APT E R
8
The Economics of Banking
8.1Learning Objective
Understand bank balance sheets.
Bank Liabilities
Checkable Deposits
Checkable deposits Accounts against which depositors can write
checks, also called transaction deposits.
Demand deposits are checkable deposits on which banks do not
pay interest.
NOW (negotiable order of withdrawal) accounts are checking
accounts that pay interest.
Checkable deposits are liabilities to banks and assets to
households and firms.
Nontransaction Deposits
The most important types of nontransaction deposits are savings
accounts, money market deposit accounts (MMDAs), and time
deposits, or certificates of deposit (CDs).
Checkable deposits and small-denomination time deposits are
covered by federal deposit insurance.
CDs of less than $100,000 are called small-denomination time
deposits. CDs of $100,000 or more are called large-denomination
time deposits.
CDs worth $100,000 or more are negotiable, which means that
investors can buy and sell them in secondary markets prior to
maturity.
Federal deposit insurance A government guarantee of deposit
account
balances up to $250,000.
The Basics of Commercial Banking: The Bank Balance Sheet
Borrowings
Banks often make more loans than they can finance with funds
they attract from depositors.
Bank borrowings include short-term loans in the federal funds
market, loans from a banks foreign branches or other subsidiaries
or affiliates, repurchase agreements, and discount loans from the
Federal Reserve System.
Although the name indicates that government money is involved,
the loans in the federal funds market involve the banks own funds.
The interest rate on these interbank loans is called the federal
funds rate.
With repurchase agreementsotherwise known as repos, or RPs
banks sell securities, such as Treasury bills, and agree to
repurchase them, typically the next day. Repos are typically
between large banks or corporations, so the degree of
counterparty risk is small.
The Basics of Commercial Banking: The Bank Balance Sheet
Making the
Connection
Bank Assets
Bank assets are acquired by banks with the funds they receive from
depositors, with funds they borrow, with funds they acquired initially
from their shareholders, and with profits they retain from their
operations.
Reserves and Other Cash Assets
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.
Securities
Marketable securities are liquid assets that banks trade in financial
markets.
Banks are allowed to hold securities issued by the U.S. Treasury
and other government agencies, corporate bonds that received
investment-grade ratings when they were first issued, and some
limited amounts of municipal bonds, which are bonds issued by
state and local governments.
Because of their liquidity, bank holdings of U.S. Treasury securities
are sometimes called secondary reserves.
In the United States, commercial banks cannot invest checkable
deposits in corporate bonds or common stock.
Loans
The largest category of bank assets is loans. Loans are illiquid
relative to marketable securities and entail greater default risk and
higher information costs.
There are three categories of loans:
(1) loans to businessescalled commercial and industrial, or C&I,
loans;
(2) consumer loans, made to households primarily to buy
automobiles, furniture, and other goods; and
(3) real estate loans, including both residential and commercial
mortgages.
The development of the commercial paper market in the 1980s
meant that banks also lost to that market many of the businesses
that had been using short-term C&I loans.
The Basics of Commercial Banking: The Bank Balance Sheet
Loans
Figure
8.1
The Changing Mix of
Bank Loans, 19732010
Other Assets
Other assets include banks physical assets, such as
computer equipment and buildings. This category also
includes collateral received from borrowers who have
defaulted on loans.
Bank Capital
Bank capital, also called shareholders equity, or bank net worth, is
the difference between the value of a banks 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 banks capital equals the funds contributed by the banks
shareholders through their purchases of stock the bank has issued
plus accumulated retained profits.
Note that as the value of a banks assets or liabilities changes, so
does the value of the banks capital.
Solved
Problem
8.1
Solved
Problem
8.1
Solved
Problem
8.1
8.2Learning Objective
Describe the basic operations of a commercial bank.
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
Making the
Connection
ROA and ROE are related by the ratio of a banks assets to its
capital:
8.3Learning Objective
Explain how banks manage risk.
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 borrowersa case
of adverse
selection.
Managing
Bank Risk
8.4Learning Objective
Explain the trends in the U.S. commercial banking industry.
Figure
8.2
Commercial Bank Failures in the United States, 19802010
Bank failures in the United States were at low levels from 1960 until the savings
and loan crisis of the mid-1980s. By the mid-1990s, bank failures had returned to
low levels, where they remained until the beginning of the financial crisis in 2007.
Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come
to rely on to earn fee income include:
1. Standby letters of credit.
Standby letter of credit A promise by a bank to lend funds, if
necessary, to a seller of commercial paper at the time that the
commercial paper matures.
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.
Off-Balance-Sheet Activities
Four important off-balance-sheet activities that banks have come
to rely on to earn fee income include:
3. Loan sales.
Loan sale A financial contract in which a bank agrees to sell the
expected future returns from an underlying bank loan to a third
party.
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.
Electronic Banking
The first important development in electronic banking was the
spread of automatic teller machines (ATMs).
By the mid-1990s, virtual banks, or banks that carry out all their
banking activities online, began to appear.
By the mid-2000s, most traditional banks had also begun providing
online services.
Check clearing is now done electronically.
Making the
Connection
Making the
Connection