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17/09/2020 08:57:28 PM

THE BALANCE SHEET OF COMMERCIAL BANKS

A bank’s balance sheet says that: total bank assets = total bank liabilities + bank capital

Banks obtain funds from individual depositors and businesses, as well as by borrowing from other financial institutions and through the financial markets. They use these funds to make loans, purchase marketable securities, and hold cash

Bank’s capital or net worth is the value of the bank to its owners

The bank’s profits = service fees + return on assets – pay for liabilities

1.2.1 Liabilities: Sources of funds

To finance their operations, banks need funds. They get them from savers and from borrowing in the financial markets. To entice individuals and businesses to place their funds in the bank, institutions offer a range of deposit accounts that provide safekeeping and accounting services, access to the payments system, liquidity, and diversification of risk, as well as interest payments on the balance. There are two types of deposit accounts, transaction and nontransaction accounts.

1.2.1.1 Checkable Deposits

Banks offer customers a variety of options that fall into the category of checking accounts, including NOW, super-NOW, insured market rate accounts, MMDA, ATS.

1.2.1.2 Nontransaction deposits

Nontransaction deposits include savings and time deposits. Savings deposits are known as passbook savings accounts. Time deposits are certificates of deposit with a fixed maturity (small and large CDs). When you place your savings in a CD at your local bank, it is as if you are buying a bond issued by that bank. But unlike government or corporate bonds, there isn’t much of resale market for your small CD. So if you want to withdraw your funds before the CD matures, you must get them back from the bank. To discourage early withdrawals, banks charge a significant penalty.

1.2.1.3 Borrowings

Borrowing is the second most important source of bank funds. Bank borrows in a number of ways. First, they can borrow from the Central Bank called discount loans. The other way is borrowing through Federal funds market (interbank market). This is banks with excess reserves will lend their surplus funds to banks that need them. Loan made in interbank market are unsecured – they lack collateral – so the lending bank must trust the borrowing bank.

Finally, banks borrow using an instrument called a repurchase agreement or Repo, a short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date, as soon as the next day

1.2.2 Assets: Uses of Funds

Let’s start with the assets side of the balance sheet – what bank do with the funds they raise. Assets of bank are what bank claims against other institutions or people. They are divided into four broad categories: cash, securities, loans, and all other assets.

1.2.2.1 Cash Items

Cash assets are of three types. The first and most important is reserves. Bank hold reserves because regulations require it and because prudent business practice dictates it. Reserves include cash in the bank’s vault (vault cash) and bank’s deposits at the Central Bank. The goal is setting requirements high enough to ensure sufficient liquidity of the Banking System without unnecessarily cutting into profits. It is held to meet customers’ withdrawal requests.

Cash items also include what are called cash items in process of collection. When you deposit your paycheck into your checking account, several days may pass before your bank can collect the funds from your employer’s bank. In the meantime, the uncollected funds are considered your bank’s asset, since the bank is expecting to receive them.

Finally, cash includes the balances of the accounts that banks hold at other banks. In the same way that individuals have checking accounts at the local bank, small banks have deposit accounts at large banks, and those accounts are classified as cash.

1.2.2.2 Securities

The second largest component of bank assets is marketable securities. While banks in some countries can hold stock, U.S banks cannot.

Bank’s bond holdings are split between U.S government bonds and agency securities bonds.

These are very liquid and are a good backup for the bank’s cash balances. They can be sold quickly if the bank needs cash. For this reason, securities are sometimes referred to as secondary reserves

1.2.2.3 Loans

This is how they earn their most profit, but loans also carry risk. We can divide loans into five broad categories: Business loans, called commercial and industrial (C&I) loans; real estate loans, including home and commercial mortgages as well as and home equity loans; consumer loans like auto loans and credit card loans; interbank loans; and other types, including loans for the purchase of other securities. These types of loans vary considerably in their liquidity. Some, like home mortgages and auto loans, usually can be securitized and resold. Others, like small business loans, may be nearly impossible to resell.

The primary difference among various depository institutions is in the composition of their loan portfolio. Commercial banks make loans primarily to businesses; savings and loans provide mortgages to individuals; credit unions specialize in consumer loans.