The basic accounting identity:
Things of value = Claims on those things (this is a stock measure)
Balance Sheets:
All resources are owned by someone. Things of value are called assets and claims on those things are called liability.
assets = liability
Subcategories of liability:
1. claims held by outsiders (liability) outsiders' claims are paid first (fixed claim)
(a) long term: paid after long term (junior claims)
(b) short term: paid before long terms. (senior claims) For example, you can withdraw money from checking account whenever u want.
2. claims held by insiders (owners of equity) (residual claim)
Assets
(1) long term assets
(2) short term
Balance sheet of a typical commercial bank
Assets Liabilities
reserves 4% deposits 18% (checking account)
loans 68% time deposits 48% (saving account)
securities 23% other liabilities 26%
other assets 5% equity 8%
Reserves are what a bank uses to execute payments on its customers' behalf (move money from one account to another)
Reserve ratio= reserves/deposits =4%/18%=22%
Capital ratio= equity/total assets = 8%/100%=8%
What's the point of the bank? To make equity bigger
(1) increase liability
(2) issue stocks
How balance sheet changes
Scenario 1: A person deposits 10 $
Liability: deposit + 10 $
Assets: reserve + 10 $
Scenario 2: A person withdraw 15$ of cash from the ATM machine
Liability: deposits - 15$
Assets: reserves - 15$
Scenario 3: A person writes a check of $15 to another one
Liability: deposits - 15$
Assets: reserves - 15$
Scenario 4: The bank makes a new loan of 30$ to its depositor at the same bank
Assets: loan + 30$
Liability: deposits + 30$
Suppose the bank invests the money in a banana factory:
Assets: reserves - 30$
Liability: deposits - 30$
Suppose it turns out that the bank's investment is worth only 5$
Assets: loan - 25$
Liability: equity - 25%
When the loans go bad, equity holders are worse off
Suppose a customer wants to pay the 75$ for the 30$ loan
Assets: reserves + 75$, loan - 30$
Liability:equity + 45%
Suppose the bank buys 40$ of the subprime mortgage
Assets: reserves - 40$, securities + 40$
Scenario 5: Suppose bank doesn't have money around, they can turn to federal funds market.
Liability: federal funds loan
Assets: reserves
Scenario 6: bank issues new equity by 55$
Assets: reserves + 55$
Liability: equity + 55$
If the value of the equity falls by 20$
Assets: reserves - 20$
Liability: equity - 20$
Three ways to structure the balance sheets:
least leveraged, moderately leveraged, highly leveraged
(1) 100% capitalized firm
Assets Liability
Investment 100$ Liability 0
Equity $100
Appreciation 5%, Investment now becomes 105$, and equity becomes 105$.
A 5% increase of value in securities translates into a 5% return of investment
A 5% decrease of value results in 5% loss of investment
It is unlikely bank will run bankrupt
(2) 50 % capitalized firm
Assets Liability
Investment 100 Liability 50
Equity 50
Capital ratio = 50%
Leverage= 1:1 , leverage: of all the stuff you owe people what shares are owed to outsiders as compared to insiders.
Appreciation 5%. Investment 105$, equity 55$
equity increases by 10%
5% loss in market results in 10% loss in firm
A loss of 50% in the value of investment results in firm's bankruptcy
(3) Highly leveraged firm
Assets Liability
investment 100 liability 97
equity 3
capital ratio= 3%
leverage 97:3
Plain-vanilla housing finance:
Assets Liability
cash reserve 100 deposit 1000
mortgage 1900 long term loans 600
equity 400
capital ratio: 20%
leverage: 4:1
This bank is healthy
When shit happens on asset side or liability side:
Problem on the asset side: solvency shocks
Problem on the liability side: liquidity shocks
Solvency shocks: banks are making bad investments
Liquidity shocks: withdraw rates are high
It is easy that a solvency shock turns into a liquidity shock:
When banks make bad investments, customers may freak out and withdraw the money, causing a liquidity shock.
A healthy system may also be toppled down because of animal spirit.
Suffering from liquidity shock, banks may have to sell healthy assets, driving down the value of the assets. (supply increases and price decreases)
Piggy bank (solvency shock) Piggy bank (liquidity shock)
Assets Liability Assets Liability
Reserve 1000 Deposit 10000 Reserve 10000 deposit 10000
Short term asset 2000 Long term loans 5000 Short term 2000 Long term loans 5000
Long term asset 7000 equity 3000 Long term 7000 equity 3000
Bus asset 8000 Bus asset 8000
18000 18000 18000 18000
Suppose long term asset goes bad, at a loss of 4000$. Equity loses 4000$, at value -1000$, more obligation to pay
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