CHAPTER FOUR
BANKING AND ITS MANAGEMENT
This chapter discusses the following important
points;
4.1 The Bank Balance Sheet
4.2 Basic Banking Activities
4.3 General Principles of Bank Management
4.4 Measuring Bank Performance
What is the meaning of bank?
Bank is defined as a financial institution that
accept money in the form of deposit and then
make loans so as to generate profit.
4.1 The Bank Balance Sheet
To understand how banking works, we start by
looking at the bank balance sheet, a list of the
bank’s assets, liabilities and capital. As the name
implies, this list balances; that is, it has the
characteristic that:
Total assets = total liabilities + capital
Cont…
A bank’s balance sheet is also a list of its sources
of bank funds (liabilities) and uses to which the
funds are put (assets). Banks obtain funds by
borrowing and by issuing other liabilities such
as deposits. They then use these funds to
acquire assets such as securities and loans.
Banks make profits by charging an interest rate
on their asset holdings of securities and loans
that is higher than the interest and other
expenses on their liabilities.
Cont…
Liabilities - A bank acquires funds by issuing
(selling) liabilities, such as deposits, which are the
sources of funds the bank uses. The funds obtained
from issuing liabilities are used to purchase income
earning assets.
Checkable Deposits: are bank accounts that allow
the owner of the account to write checks to third
parties. Checkable deposits include all accounts on
which checks can be drawn: non-interest-bearing
checking accounts (demand deposits), interest-
bearing negotiable order of withdrawal (NOW)
accounts, and money market deposit accounts
Cont…
Checkable deposits and money market deposit
accounts are payable on demand; that is, if a
depositor shows up at the bank and requests
payment by making a withdrawal, the bank must
pay the depositor immediately. Similarly, if a
person who receives a check written on an
account from a bank presents that check at the
bank, it must pay the funds out immediately (or
credit them to that person’s account).
Cont…
A checkable deposit is an asset for the
depositor because it is part of his or her wealth.
Because the depositor can withdraw funds and
the bank is obligated to pay, checkable deposits
are a liability for the bank. They are usually the
lowest cost source of bank funds because
depositors are willing to forgo some interest to
have access to a liquid asset that can be used to
make purchases.
Cont…
Non-transaction Deposits: are deposits in
which owners cannot write checks on non-
transaction deposits, but the interest rates
paid on these deposits are usually higher
than those on checkable deposits. There are
two basic types of non-transaction deposits:
savings accounts and time deposits (also
called certificates of deposit, or CDs).
Cont…
Borrowings : obtain funds by borrowing from
the Federal Reserve System, the Federal Home
Loan banks, other banks, and corporations.
Borrowings from the Fed are called discount
loans (also known as advances).
Bank Capital - bank’s net worth, which equals
the difference between total assets and
liabilities. Bank capital is raised by selling new
equity (stock) or from retained earnings. Bank
capital is a cushion against a drop in the value
of its assets, which could force the bank into
insolvency.
Cont…
Assets - A bank uses the funds that it has
acquired by issuing liabilities to purchase
income earning assets. Bank assets are thus
naturally referred to as uses of funds, and the
interest payments earned on them are what
enable banks to make profits.
Reserves: Reserves are these deposits plus
currency that is physically held by banks (called
vault cash because it is stored in bank vaults
overnight). Although reserves currently do not
pay any interest, banks hold them for two
reasons.
Cont…
First, some reserves, called required reserves,
are held because of reserve requirements, the
regulation that for every dollar of checkable
deposits at a bank, a certain fraction must be
kept as reserves. This fraction is called the
required reserve ratio. Banks hold additional
reserves, called excess reserves, because they
are the most liquid of all bank assets and a bank
can use them to meet its obligations when funds
are withdrawn, either directly by a depositor or
indirectly when a check is written on an account.
Cont…
Cash Items in Process of Collection: Suppose
that a check written on an account at another
bank is deposited in your bank and the funds
for this check have not yet been received
(collected) from the other bank. The check is
classified as a cash item in process of
collection, and it is an asset for your bank
because it is a claim on another bank for funds
that will be paid within a few days.
Cont…
Deposits at Other: Many small banks hold
deposits in larger banks in exchange for a
variety of services, including check collection,
foreign exchange transactions, and help with
securities purchases. This is an aspect of a
system called correspondent banking.
Collectively, reserves, cash items in process
of collection, and deposits at other banks are
referred to as cash items.
Cont…
Securities: A bank’s holdings of securities are
an important income-earning asset: Securities
made up entirely of debt instruments for
commercial banks, because banks are not
allowed to hold stock.
Loans: Banks make their profits primarily by
issuing loans. A loan is a liability for the
individual or corporation receiving it, but an
asset for a bank, because it provides income
to the bank.
Cont…
Loans are typically less liquid than other assets,
because they cannot be turned into cash until
the loan matures. If the bank makes a one-year
loan, for example, it cannot get its funds back
until the loan comes due in one year. Loans also
have a higher probability of default than other
assets. Because of the lack of liquidity and higher
default risk, the bank earns its highest return on
loans.
Other Assets: The physical capital (bank
buildings, computers, and other equipment)
4.2 Basic Banking Activities
In general terms, banks make profits by selling
liabilities with one set of characteristics (a
particular combination of liquidity, risk, size, and
return) and using the proceeds to buy assets
with a different set of characteristics. This
process is often referred to as asset
transformation. Bank borrows short and lends
long. To show how banks work, consider the
following illustration;
Cont…
Let’s say that Sara Alex has heard that the First
National Bank provides excellent service, so she
opens a checking account with a $100 bill. She
now has a $100 checkable deposit at the bank,
which shows up as a $100 liability on the bank’s
balance sheet. The bank now puts her $100 bill
into its vault so that the bank’s assets rise by the
$100 increase in vault cash. The T-account for
the bank looks like this:
Cont…
T- account analysis
Deposit of $100 cash into First National Bank
First National Bank
Assets Liabilities
Vault cash $100 Checkable deposit $100
Note that Sara Alex’s opening of a checking
account leads to an increase in the bank’s reserves
equal to the increase in checkable deposits.
Cont…
If Sara had opened her account with a $100
check written on an account at another bank,
say, the Second National Bank, we would get the
same result. The initial effect on the T-account of
the First National Bank is as follows:
-Deposit of $100 check
Assets Liabilities
Cash item in the $ 100 Checkable deposits $100
Process of collection
Cont…
The same effect
First National Bank
Assets Liabilities
Reserves $100 Checkable deposits $100
Second National Bank
Assets Liabilities
Reserves $100 Checkable deposits $100
Note that when bank receives deposits, reserves
increase by equal amount; when bank loses deposits,
reserves decreases by equal amount.
Cont…
When a bank gets deposit, it is obliged to keep a
certain fraction of its checkable deposits as
required reserves. If the fraction (the required
reserve ratio) is 10%, the First National Bank’s
required reserves have increased by $10, and we
can rewrite its T-account as follows:
- Deposit of $100 cash into First National Bank
assuming Required Reserve ratio of 10%.
Cont…
First National Bank
Assets Liabilities
Required reserves $10 Checkable deposit $100
Excess reserves 90
- $10 of the deposit must remain in reserves to
meet federal regulations (10% reserve req.).
- Now, the bank is free to work with the $90 in
its asset transformation function. In this case,
the bank loans the $90 to its customers.
Cont…
Let us assume that the bank chooses not to hold
any excess reserves but to make loans instead.
The T-account then looks like this:
- Loaning out excess reserves
Assets Liabilities
Required reserves $10 Checkable deposits $100
Loans 90
The bank is now making a profit because it holds short-term
liabilities such as checkable deposits and uses the proceeds to buy
longer-term assets such as loans with higher interest rates. As
mentioned earlier, this process of asset transformation is
frequently described by saying that banks are in the business of
“borrowing short and lending long.”
4.3 General Principles of Bank Management
Bank manages its assets and liabilities to earn
the highest possible profit. The bank manager
has four primary concerns.
- Liquidity Management
- Asset Management
- Liability Management
- Capital Adequacy Management
(refer to your note)
4.4 Measuring Bank Performance
To understand how well a bank is doing, we need
to start by looking at a bank’s income statement,
the description of the sources of income and
expenses that affect the bank’s profitability.
Bank’s Income Statement – this summarizes
operating income and operating expenses of
banks.
-Operating Income: comes from a bank’s ongoing
operations. Most of a bank’s operating income is
generated by interest on its assets, particularly
loans.
Cont…
- Operating Expenses: Operating expenses are
the expenses incurred in conducting the
bank’s ongoing operations. An important
component of a bank’s operating expenses is
the interest payments that it must make on its
liabilities, particularly on its deposits. Just as
interest income varies with the level of
interest rates, so do interest expenses.
- Income: the difference between operating
income and operating expense.
Cont…
Income statement
Interest income
- Interest expenses
Net interest profits
+ Non interest income (fees and gains/losses on securities)
Profit from intermediation
- Operating costs
Net operating profits
+/- Extraordinary items
- Income tax
Net profit or Profit after tax
Cont…
Measures of Bank Performance
- Return on Assets (ROA) - The return on assets
provides information on how efficiently a bank
is being run, because it indicates how much
profits are generated on average by each
dollar of assets. It is given by;
ROA = net profit after taxes / assets
- Return on Equity (ROE) – measures how much
profits are generated on average from each
dollar of equity investment. It is given by;
ROE = net profit after taxes / equity capital
Cont…
- Equity multiplier (EM) – shows the amount of
assets per dollar of equity capital. It is given as
follows;
EM = assets / equity capital
Note that ROE = ROA x EM
- Net interest margin (NIM) - the difference
between interest income and interest
expenses as a percentage of total assets. It is
given as follow;
NIM = (interest income - interest expenses) /
assets
END
