The banking firm and the management of financial institutions

The bank balance sheet:
Total assets = total liabilities + capital

Liabilities (sources if funds)
(1) checkable deposits:
bank accounts that allow the owner of the account to write checks to third parties. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to to a liquid asset that can be used to make purchases.

(2) Non-transaction deposits
owners cannot write checks on them, but the interest rates are usually higher than those on checkable deposits.
(a) savings account
(b) time deposits, which are also called certificate of deposit, or CD

(3) Borrowings
funds borrowed from the Fed, other banks and corporations/ Borrowing from the Fed is called discount loans (or advances). They also borrow overnight in federal funds market from other US banks and financial institutions to have enough deposits at the Federal Reserve to meet the amount required by the Fed.

(4) Bank Capital
a cushion against a drop in the value of its assets

Assets (Uses of funds)
(1) reserves
All banks hold some of the funds they acquire as deposits in an account at the Fed. RESERVES are these deposits plus currency that is physically held by banks (called VAULT CASH because it is stored in bank vaults overnight)

The reasons to hold reserves (a) required reserves are mandated by law (b) additional reserves, called excess reserves, are the most liquid of all bank assets and can be used by a bank to meet its obligation when funds are withdrawn, either directly by a depositor or indirectly when a check is written on an account.

(2) securities

(3) loans
less liquid than other assets because they cannot be turned into cash until the loan matures.

(4) other assets (physical)

In general terms, banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics. (asset transformation) Transform the saving asset (asset held by the depositor) to a mortgage loan (asset held by the bank)

When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses deposits, it loses an equal amount of reserves.

IF a bank has ample reserves, a deposit outflow doesn't necessitate changes in other parts of balance sheets

liquidity management: the acquisition of sufficiently liquid assets to meet the bank's obligation to depositors

asset management: pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings

liability management: acquire funds at low cost (negotiable CDs and federal fund market)
a bank maintains bank capital to lessen the chance that it will become insolvent
net profit after taxes/equity capital = net profit / assets * assets / equity capital
(given the return on assets, the lower the bank capital, the higher the return for the owners of the bank)
bank capital requirements

capital adequacy management: the amount of capital should maintain and capital needed


The reasons why banks hold excess reserve:
When a deposit outflow occurs, holding excess reserves allows the bank to escape the cost of (1) borrowing from other banks or corporations (2) selling securities (3) borrowing from federal (4) selling loans. Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs associated with deposit outflows, the more excess reserves banks will want to hold.