3 sept 16

• Bank Accounting and Fractional Reserve Banking (Review)

• Bank Capital and Profitability• The Money Multiplier• Change in Total Deposits• Change in the Money Supply

Bank Balance Sheet

Assets (A) Liabilities (L)

Bank Capital (= A – L)

Anything the bank owns

Any amount the bank is owed

DepositsSavings Deposits

Checking Deposits

(Often called “bank capital”)

Bank Balance Sheet



Bank Balance Sheet



Reserves

Bank Balance Sheet



ReservesVault Cash

Bank Balance Sheet



ReservesVault Cash

Deposits with the Fed

Bank Balance Sheet



ReservesVault Cash


Loans

Bank Balance Sheet



ReservesVault Cash


Loans

Bonds

Bank Balance Sheet



ReservesVault Cash


Loans

BondsOther Assets

Bank Balance Sheet



ReservesVault Cash


Loans

BondsOther Assets

Checking Deposits

Savings Deposits

The Balance Sheet HAS TO Balance

NW = A – L

A = L + NW (or Capital)

Bank Capital and Profitability

• Remember that net worth equals assets minus liabilities.

• Net worth is referred to as bank capital, or equity capital.

• We can think of capital as the owners’ stake in the bank.

• Capital is the cushion banks have against a sudden drop in the value of their assets or an unexpected withdrawal of liabilities.• It provides some insurance against insolvency.


• An important component of bank capital is loan loss reserves:• Loan loss reserves are an amount the bank sets

aside to cover potential losses from defaulted loans.

• At some point the bank gives up hope a loan will be repaid and it is written off, or erased from the bank’s balance sheet.

• At this point, the loan loss reserve is reduced by the amount of the loan that has defaulted.


• The ratio of debt to equity in the U.S. banking system was about 8 to 1 in January 2013.

• Although that is a substantial amount of leverage, it is nearly 25% below the average commercial bank leverage ratio that prevailed prior to the financial crisis of 2007-2009.• Debt-to-equity ratio for nonfinancial business in the

U.S. is less than 1 to 1.• Household leverage is roughly 1/3 to 1.

• Leverage increases risk AND expected return.


• One of the explanations for the relatively high degree of leverage in banking is the existence of government guarantees like deposit insurance.• These government guarantees allow banks to

capture the benefits of risk taking without subjecting depositors to potential losses.


There are several measures of bank profitability.

1. Return on assets (ROA).• ROA is the bank’s profit left after taxes

divided by the bank’s total assets.

• It is a measure of how efficiently a particular banks uses its assets.

• This is less important to bank owners than the return on their own investment.

Net profit after taxes

Total bank assetsROA


2. The bank’s return to its owners is measured by the return on equity (ROE).• This is the bank’s net profit after taxes divided

by the bank’s capital.

• ROA and ROE are related to leverage.• One measure of leverage is the ratio of

banks assets to bank capital.• Multiplying ROA by this ratio yields ROE.


Bank capitalROE


ROE Net profit after taxes

Bank Capital

ROA *Bank Assets

Bank Capital


Total bank assets*

Bank Assets

Bank Capital


Bank capitalROE


• Prior to the financial crisis of 2007-2009, the typical U.S. bank has a ROA of about 1.3%.

• For large banks, the ROE tends to be higher than for small banks, suggesting greater leverage, a riskier mix of assets, or the existence of significant economies to scale in banking.• The poor performance during the crisis and

moderate returns after, suggests their high returns were at least partly due to more leverage or a riskier mix of assets.


3. The final measure of bank profitability is net interest income.• This is related to the fact that banks pay interest on

their liabilities and receive interest on their assets.• Deposits and bank borrowing rate interest expenses;

securities and loans generate interest income.

• The difference between the two is net interest income.


• Net interest income can also be expressed as a percentage of total assets to yield: net interest margin.• This is the bank’s interest rate spread - the

weighted average difference between the interest rate received on assets and the interest rate paid for liabilities.

• Well-run banks have a high net interest income and a high net interest margin.• If a bank’s net interest margin is currently

improving, its profitability is likely to improve in the future.

Money Multiplier: Step 1Somebody Deposits $10,000 in

Bank of America


Bank Capital

Reserves

Loans

Checking Deposits


Bank of America


Bank Capital

Reserves +$10K Checking Deposits +$10K

Total New Deposits

$10,000 Original Deposit


Bank of America


Bank Capital

Reserves +$10K

- New Loans $9K

Checking Deposits +$10K


Bank of America


Bank Capital

Reserves +$10K

-New Loans $ 9K

Loans +$ 9K



Bank of AmericaFinal Changes in Balance Sheet


Bank Capital

Reserves +$1K

Loans +$9K


Money Multiplier$9,000 loaned out by BOA ends up in

Cambridge Savings Bank


Bank Capital

Reserves +$9K

Loans


Total New Deposits

$10,000 Original Deposit in BOA

$ 9,000 Deposit in CSB

Money Multiplier: Step 2Final Balance Sheet of Cambridge

Savings Bank


Bank Capital

Reserves +$ 900

Loans +$ 8,100


Total New Deposits



$ 8,100 Deposit in Sovereign Bank

Total New Deposits




$ 7,290 Deposit in Citibank

Total New Deposits




$ 7,290 Deposit in Citibank

$ 6,561 Deposit in Capital One

Money Multiplier Process

Deposit → Loan

→ Deposit → Loan

→ Deposit → Loan

→ . . . . etc.

Total Change in Deposits

Total Deposits Initial Deposit 1

R

where R = the reserve requirement

If E = the percentage of their deposits banks are holding as excess reserves……


is called the "money multiplier"R+E

1

R+E

Total Change in the Money Supply


is called the "money multiplier"R+E

1

R+E

Money Supply Total Deposits

Cash held by the public

Two Fundamental Equations of Money Creation


R+E



Total Change in Depositsand Money SupplyExample:

$10,000 DepositR = 10%E = 0%


R+E

$10,0001

.1+0

$10,000 10

$100,000



R+E

$100,000



$100,000 ($10,000)

$90,000

Excess Reserves Before and During the Crisis


What if E = 10%?

Money multiplier 1

R+E

1

.1+.1

1

.2

5

R still = 10%


$10,000 DepositR = 10%E = 10%


R+E

$10,0001

.1+.1

$10,000 5

$50,000



R+E

$50,000



$50,000 ($10,000)

$40,000

Reverse Money Multiplier Process

What happens if somebody withdraws $10,000 from the bank?

Sets in motion the reverse money multiplier process

Someone Withdraws $10,000 from Bank of America



Reserves −$10,000 Deposits −$10,000

Required Reserves ↓by $1,000

Actual Reserves ↓by $10,000

Bank is $9,000 short of reserves


Four options when a bank is short of reserves:

1. Borrow the needed reserves from another bank on the “Fed Funds” market

2. Borrow the needed reserves from the Fed at the “discount window”

3. Reduce loans

4. Sell securities (bonds)

Eventually, some bank will need to do (3) or (4)

Bank of America



Reserves +$9,000

Loans −$9,000

Citizen’s Bank





Sovereign Bank






Withdrawal → Loan reduction

→ Withdrawal → Loan reduction

→ Withdrawal → Loan reduction

→ . . . . etc.


$10,000 DepositR = 10%E = 0%


R+E

$10,0001

.1+0

$10,000 10

$100,000

Reverse Money Multiplier ProcessExample:

$10,000 WithdrawalR = 10%E = 0%


R+E

$10,0001

.1+0

$10,000 10

Reverse Money Multiplier ProcessExample:


R+E

$100,000



$100,000 $10,000

$90,000

3 sept 16

Documents

equity capital

capitalbank capital

bank accounting

bank ownsany

bank sets

banks balance sheet

measures of bank profitability

profitabilitythe banks