The bank’s balance sheet.Definitions, etc.

Managing the bank’s balance sheet:

1. Liquidity management.

ECON7003 Money and Banking. Hugh Goodacre

Lecture 3.

PRINCIPLES OF BANK MANAGEMENT (1)

Four core / traditional principles of bank management:

Liquidity management.

Asset management.

Liability management (only to prominence since 1960s).

Capital adequacy management.

These four principles all concern management of the bank’s balance sheet.

This has two columns; Assets and Liabilities:

Liabilities – sources of the bank’s funds.

Assets – uses to which the bank puts these funds.

Reserves 75m

Loans 300m

TOTAL 600m

Deposits 500m

Bank Capital 100m

TOTAL 600m

Assets Liabilities

Example of a bank’s balance sheet:

Securities 225m

Reserves consist of:‘Vault Cash’ (UK: ‘Cash in Till).Funds held by the bank in its account at the Central Bank

If a cheque for £100 is drawn upon Bank I and is paid by the recipient into Bank II, then Bank I owes Bank II £100.

This debt is paid through the clearing system at the Central Bank:

The CB withdraws £100 from the account of debtor bank (A) and pays it into the creditor bank (B).

There is thus a one-to-one relation between deposits and reserves.

Reserves - 100 Deposits - 100

Assets Liabilities

Bank I

Reserves + 100 Deposits + 100

Assets Liabilities

Bank II

‘T-accounts’: These are simplified balance sheets listing only the changes that occur in balance sheet items starting from an initial balance sheet position.

CB has transferred £100 from reserves of I to II

Reserves + 100 Deposits + 100

Assets Liabilities

Bank II

Bank II has now gained £100 in reserves. Say it has a Required Reserve Ratio of 10%.It thus has an additional £90 of Excess Reserves.

Required Reserves +10 Deposits +100

Assets Liabilities

Bank II

Excess Reserves +90

It can use these ER to invest in interest bearing assets (reserves earn no interest).

Bank profit:

Revenue from assets, e.g.• interest from loans, securities, etc.

less

Costs incurred on liabilities, e.g.Costs of servicing a deposit account:

• keeping records• sending statements• paying cashiers• maintaining buildings/branches• returning cancelled cheques• cheque clearing charges• advertising and marketing costs• interest paid to depositor (if interest-bearing account).

Recall: Bank II gained £90 of Excess Reserves as a result of A’s deposit.It now uses the addition to its ER to make a loan to B at 10%.

Required Reserves + 10 Deposits from A + 100

Assets Liabilities

Bank II

Loan to B + 90

It pays A 5% on his/her deposit.An additional cost of 3% is incurred in servicing this account.

Its profit is thus: Revenue on asset side: £9

less Costs incurred on liabilities side: £5 + £3 = £8

= £1

Return on Assets: Profit (i.e. revenue net of costs) as percentage of total assets.

When it first received A’s deposits the resulting return on its increase in assets was nil:

Reserves receive no interest → ROA = 0/100 = 0%.

Required Reserves + 10 Deposits + 100

Assets Liabilities

Bank II

Excess Reserves + 90

But once it had used the addition to its ER to make a loan to B, it made a profit of £1.

→ ROA = 1/100 = 1%.

Bank Capital.

The difference between a bank’s assets and liabilities.

→ alternatively defined as ‘net worth’.

Included in the liabilities column of the balance sheet.

Bank Capital 100m

TOTAL 600m

Reserves 75m

Loans 300m

TOTAL 600m

Deposits 500m

Assets Liabilities

Securities 225m

Core principles of bank management.

1. Liquidity management. 2. Asset management.3. Liability management.4: Capital adequacy management.

(1) Liquidity management.

Sustain adequate liquidity to meet deposit outflow

Deposit outflow means equivalent loss of reserves

→ Liquidity management is equivalent to

Reserve adequacy management.

Replenishing reserves

Original / ‘traditional’ means:

Adjust the balance sheet:

Borrow from other banks or firms, or Central Bank (discount loans).

Sell securities.

Call in or sell off loans.

BUT: Rearranging balance sheet is costly:

Borrowings: Payment of interest.

Sell securities: Loss of interest.

Calling in loans: Loss of interest.

BUT ALSO / most costly of all:

Also damage to customer relationships.

Probable ‘fire sale’ conditions → poor price:

Loss of subjective / informational value.

ER thus traditionally a form of insurance / ‘cushion’ against these costs.

In fact largely superseded in recent decades:

Other forms of insurance -- hedging / derivatives, etc.

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Note the very low ER of US banks since the early 1960s.Note also inverse relationship to interest rate.

Dwindles almost to zero when r is high.

A bank’s Assets are: reserves £20m, loans £80m, securities £10m.Its Liabilities are £100m deposits.Its RRR is 10%.It now faces a deposit withdrawal of £10m.

Bank Capital 10m

TOTAL 110m

Reserves 20m

Loans 80m

TOTAL 110m

Deposits 100m

Assets Liabilities

Securities 10m

T-account after the deposit withdrawal:

Bank Capital 10m

TOTAL 100m

Reserves 10m

Loans 80m

TOTAL 100m

Deposits 90m

Assets Liabilities

Securities 10m

No action is needed to replenish reserves following this withdrawal:

RRR of 10% → only 9m reserves required.

There remain 1m ER.

Bank Capital 10m

TOTAL 110m

Reserves 10m

Loans 80m

TOTAL 110m

Deposits 100m

Assets Liabilities

Securities 10m

Now suppose that before the deposit withdrawal the bank had made an additional loan of £10m:

Bank Capital 10m

TOTAL 100m

Reserves 0m

Loans 90m

TOTAL 100m

Deposits 90m

Assets Liabilities

Securities 10m

Action is needed to replenish reserves, which have fallen to zero.

£9m reserves required.

The bank now faces the deposit withdrawal:

Bank Capital 10m

TOTAL 110m

Reserves 10m

Loans 80m

TOTAL 110m

Deposits 100m

Assets Liabilities

Securities 10m

Now suppose that before the deposit withdrawal the bank had made an additional loan of £10m:

Bank Capital 10m

TOTAL 109m

Reserves 9m

Loans 90m

TOTAL 109m

Deposits 90m

Assets Liabilities

Securities 10m

Cost: Interest paid.

In case of borrowings from CB, this is the ‘Discount Rate’.

Note: The bank’s BS has here ‘expanded’.

Before borrowing, it had been only 100m

Replenishing reserves (1) Borrow from banks, firms or CB:

Borrowings 9m

Bank Capital 10m

TOTAL 100m

Reserves 9m

Loans 90m

TOTAL 100m

Deposits 90m

Assets Liabilities

Securities 1m

Cost (besides loss of interest):Transaction costs (brokerage, etc.).Can be very low in case of govt securities (Gilts, US TBs, etc.) ‘Secondary reserves’.

Replenishing reserves (2) Sell securities. → Securities fall from 10m to 1m:

Bank Capital 10m

TOTAL 100m

Reserves 9m

Loans 81m

TOTAL 100m

Deposits 90m

Assets Liabilities

Securities 10m

Cost: The costliest of all:• Damages customer relationships.• Selling loans on may be at unfavourable price:• Loss of informational element in their value.• Particularly if sold under ‘fire sale’ conditions.

Replenishing reserves (3) Call in loans. → Loans fall from 90m to 81m:

Core principles of bank management – résumé.

So far: 1. Liquidity management. Ensure bank can meet demands for deposit withdrawals.One-to-one relation between deposits and reserves means this is equivalent to reserve adequacy management.

Next: 2. Asset management.

3. Liability management.

4. Capital adequacy management.