Basic Banking—Cash Deposit Opening of a checking account leads to an increase in the bank’s reserves equal to the increase in checkable deposits First National Bank AssetsLiabilitiesAssetsLiabilities Vault Cash +$100Checkable deposits +$100Reserves+$100Checkable deposits +$100 Economics 330 Fall 2006, lecture of 25 October 2006

Basic Banking—Check Deposit First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Reserves+$100Checkable deposits +$100Reserves-$100Checkable deposits -$100 First National Bank AssetsLiabilities Cash items in process of collection +$100Checkable deposits +$100

Basic Banking—Making a Profit Asset transformation-selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics The bank borrows short and lends long First National BankSecond National Bank AssetsLiabilitiesAssetsLiabilities Required reserves +$10Checkable deposits +$100Required reserves +$10Checkable deposits +$100 Excess reserves +$90Loans+$90

Bank Management Liquidity Management Asset Management Liability Management Capital Adequacy Management Credit Risk Interest-rate Risk

Liquidity Management: Shortfall in Reserves Reserves are a legal requirement and the shortfall must be eliminated Excess reserves are insurance against the costs associated with deposit outflows AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$100MReserves$0Deposits$90M Loans$90MBank Capital $10MLoans$90MBank Capital $10M Securities$10MSecurities$10M

Liquidity Management: Borrowing Cost incurred is the interest rate paid on the borrowed funds AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBorrowing$9M Securities$10MBank Capital$10M

Liquidity Management: Securities Sale The cost of selling securities is the brokerage and other transaction costs AssetsLiabilities Reserves$9MDeposits$90M Loans$90MBank Capital$10M Securities$1M

Liquidity Management: Reduce Loans Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonizes customers Other banks may only agree to purchase loans at a substantial discount AssetsLiabilities Reserves$9MDeposits$90M Loans$81MBank Capital$10M Securities$10M

Capital Adequacy Management: Preventing Bank Failure When Assets Decline High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

Capital Adequacy Management: Returns to Equity Holders

Interest-Rate Risk If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits First National Bank AssetsLiabilities Rate-sensitive assets$20MRate-sensitive liabilities$50M Variable-rate and short-term loansVariable-rate CDs Short-term securitiesMoney market deposit accounts Fixed-rate assets$80MFixed-rate liabilities$50M ReservesCheckable deposits Long-term loansSavings deposits Long-term securitiesLong-term CDs Equity capital

Interest Rate Risk: Gap Analysis