- In five words, what do banks do?
- Without a word limitation, how would you describe what functions they fulfill?
As Figure 9.1 "Bank assets and liabilities" and Figure 9.2 "Assets and liabilities of U.S. commercial banks, March 7, 2007" show, commercial banks own reserves of cash and deposits with the Fed; secondary reserves of government and other liquid securities; loans to businesses, consumers, and other banks; and other assets, including buildings, computer systems, and other physical stuff. Each of those assets plays an important role in the bank’s overall business strategy. A bank’s physical assets are needed to conduct its business, whether it be a traditional brick-and-mortar bank, a full e-commerce bank (there are servers and a headquarters someplace), or a hybrid click-and-mortar institution. Reserves allow banks to pay their transaction deposits and other liabilities. In many countries, regulators mandate a minimum level of reserves, called required reserves. When banks hold more than the reserve requirement, the extra reserves are called excess reserves. When reserves paid zero interest, as they did until recently, U.S. bankers usually kept excess reserves to a minimum, preferring instead to hold secondary reserves like Treasuries and other safe, liquid, interest-earning securities. Banks’ bread-and-butter asset is, of course, their loans. They derive most of their income from loans, so they must be very careful who they lend to and on what terms. Banks lend to other banks via the federal funds market, but also in the process of clearing checks, which are called “cash items in process of collection.” Most of their loans, however, go to nonbanks. Some loans are uncollateralized, but many are backed by real estate (in which case the loans are called mortgages), accounts receivable (factorage), or securities (call loans).
Stop and Think Box
Savings banks, a type of bank that issues only savings deposits, and life insurance companies hold significantly fewer reserves than commercial banks do. Why?
Savings banks and life insurance companies do not suffer large net outflows very often. People do draw down their savings by withdrawing money from their savings accounts, cashing in their life insurance, or taking out policy loans, but remember that one of the advantages of relatively large intermediaries is that they can often meet outflows from inflows. In other words, savings banks and life insurance companies can usually pay customer A’s withdrawal (policy loan or surrender) from customer B’s deposit (premium payment). Therefore, they have no need to carry large reserves, which are expensive in terms of opportunity costs.
Where do banks get the wherewithal to purchase those assets? The right-hand side of the balance sheet lists a bank’s liabilities or the sources of its funds. Transaction deposits include negotiable order of withdrawal accounts (NOW) and money market deposit accounts (MMDAs), in addition to good old checkable deposits. Banks like transaction deposits because they can avoid paying much, if any, interest on them. Some depositors find the liquidity that transaction accounts provide so convenient they even pay for the privilege of keeping their money in the bank via various fees, of which more anon. Banks justify the fees by pointing out that it is costly to keep the books, transfer money, and maintain sufficient cash reserves to meet withdrawals.
The administrative costs of nontransaction deposits are lower so banks pay interest for those funds. Nontransaction deposits range from the traditional passbook savings account to negotiable certificates of deposit (NCDs) with denominations greater than $100,000. Checks cannot be drawn on passbook savings accounts, but depositors can withdraw from or add to the account at will. Because they are more liquid, they pay lower rates of interest than time deposits (aka certificates of deposit), which impose stiff penalties for early withdrawals. Banks also borrow outright from other banks overnight via what is called the federal funds market (whether the banks are borrowing to satisfy Federal Reserve requirements or for general liquidity purposes), and directly from the Federal Reserve via discount loans (aka advances). They can also borrow from corporations, including their parent companies if they are part of a bank holding company.
That leaves only bank net worth, the difference between the value of a bank’s assets and its liabilities. Equity originally comes from stockholders when they pay for shares in the bank’s initial public offering (IPO) or direct public offering (DPO). Later, it comes mostly from retained earnings, but sometimes banks make a seasoned offering of additional stock. Regulators watch bank capital closely because the more equity a bank has, the less likely it is that it will fail. Today, having learned this lesson the hard way, U.S. regulators will close a bank down well before its equity reaches zero. Provided, that is, they catch it first. Even well-capitalized banks can fail very quickly, especially if they trade in the derivatives market, of which more below.
At the broadest level, banks and other financial intermediaries engage in asset transformation. In other words, they sell liabilities with certain liquidity, risk, return, and denominational characteristics and use those funds to buy assets with a different set of characteristics. Intermediaries link investors (purchasers of banks’ liabilities) to entrepreneurs (sellers of banks’ assets) in a more sophisticated way than mere market facilitators like dealer-brokers and peer-to-peer bankers do.
More specifically, banks (aka depository institutions) engage in three types of asset transformation, each of which creates a type of risk. First, banks turn short-term deposits into long-term loans. In other words, they borrow short and lend long. This creates interest rate risk. Second, banks turn relatively liquid liabilities (e.g., demand deposits) into relatively illiquid assets like mortgages, thus creating liquidity risk. Third, banks issue relatively safe debt (e.g., insured deposits) and use it to fund relatively risky assets, like loans, and thereby create credit risk.
Other financial intermediaries transform assets in other ways. Finance companies borrow long and lend short, rendering their management much easier than that of a bank. Life insurance companies sell contracts (called policies) that pay off when or if (during the policy period of a term policy) the insured party dies. Property and casualty companies sell policies that pay if some exigency, like an automobile crash, occurs during the policy period. The liabilities of insurance companies are said to be contingent because they come due if an event happens rather than after a specified period of time.
Asset transformation and balance sheets provide us with only a snapshot view of a financial intermediary’s business. That’s useful, but, of course, intermediaries, like banks, are dynamic places where changes constantly occur. The easiest way to analyze that dynamism is via so-called T-accounts, simplified balance sheets that list only changes in liabilities and assets. By the way, they are called T-accounts because they look like a T. Sort of. Note in the T-accounts below the horizontal and vertical rules that cross each other, sort of like a T.
Suppose somebody deposits $17.52 in cash in a checking account. The T-account for the bank accepting the deposit would be the following:
|Reserves +$17.52||Transaction deposits +$17.52|
If another person deposits in her checking account in Some Bank a check for $4,419.19 drawn on Another Bank,If that check were drawn on Some Bank, there would be no need for a T-account because the bank would merely subtract the amount from the account of the payer, or in other words, the check maker, and add it to the account of the payee or check recipient. the initial T-account for that transaction would be the following:
|Cash in collection +$4,419.19||Transaction deposits +$4,419.19|
Once collected in a few days, the T-account for Some Bank would be the following:
Cash in collection −$4,419.19
The T-account for Another Bank would be the following:
|Transaction deposits +$4,419.19|
Gain some practice using T-accounts by completing the exercises, keeping in mind that each side (assets and liabilities) of a T-account should balance (equal each other) as in the examples above.
Write out the T-accounts for the following transactions.
- Larry closes his $73,500.88 account with JPMC Bank, spends $500.88 of that money on consumption goods, then places the rest in W Bank.
- Suppose regulators tell W Bank that it needs to hold only 5 percent of those transaction deposits in reserve.
- W Bank decides that it needs to hold no excess reserves but needs to bolster its secondary reserves.
- A depositor in W bank decides to move $7,000 from her checking account to a CD in W Bank.
- W Bank sells $500,000 of Treasuries and uses the proceeds to fund two $200,000 mortgages and the purchase of $100,000 of municipal bonds.
(Note: This is net. The bank merely moved $100,000 from one type of security to another.)
- In five words, banks lend (1) long (2) and (3) borrow (4) short (5).
- Like other financial intermediaries, banks are in the business of transforming assets, of issuing liabilities with one set of characteristics to investors and of buying the liabilities of borrowers with another set of characteristics.
- Generally, banks issue short-term liabilities but buy long-term assets.
- This raises specific types of management problems that bankers must be proficient at solving if they are to succeed.