CHAPTER 8 The Banking Firm and Bank Management 163

banks because they hold over two-thirds of the assets in the banking
system, the principles are just as applicable to other types of banking
institutions, such as savings and loans, mutual savings banks, and credit
unions.

THE BANK BALANCE SHEET

To understand how a bank operates, first we need to examine the bank
balance sheet, which lists its assets and liabilities. As the name implies,
this list balances: that is, it has the characteristic that
Total assets = total liabilities + capital
Furthermore, a bank's balance sheet lists sources of bank funds (liabilities)
and uses to which they are put (assets).Banks obtain funds by borrowing
and by issuing other liabilities such as deposits. They then use these funds
to acquire assets such as securities and loans. The revenue that banks
receive from their holdings of securities and loans covers the expenses of
issuing liabilities and yields a profit. The balance sheet of all commercial
banks at the end of 1987 appears in Table 8.1.

TABLE 8.1
Balance Sheet of All Commercial Banks, End of 1987 (Items as % of Total)

Assets (Uses of Funds) Liabilities (Sources of Funds)

(In order of decreasing liquidity)
Reserves 2 Checkable deposits 22
Cash items in process of Nontransaction deposits
collection Savings deposits 18
Deposits with other banks 1 Small denomination (<$100,000) 17
Time deposits
Securities Large denomination 13
U.S. government and agency 11 Time deposits
State and local government and
other securities 7 Borrowings 23

Loans Bank capital 7

Commercial and industrial 20
Mortgage 20
Consumer 12
Other loans 8
Other assets 16
(for example, physical capital)

TOTAL 100 TOTAL 100

Source: Federal Reserve Bulletin

164 PART III Financial Institutions

Liabilities
A bank acquires funds by issuing (selling) liabilities (sources of funds),
which can then be used to purchase income-earning assets.

Checkable Deposits These are accounts at a bank that entitle the

owner(s)of the account to write checks to third parties. Checkable deposits
include all types of accounts on which checks can be drawn: non-interest-
bearing checking accounts (demand deposits), interest-bearing NOW (ne-
gotiable order of withdrawal) accounts, super-NOW accounts, and the
money market deposit accounts Mi?lDAs) introduced in 1982. Table 8.1
depicts checkable deposits as an important source of bank funds, making
up 22% of bank liabilities. Once they were the most important source of
bank funds (over 60% of bank liabilities in 1960),but their share of bank
liabilities has shrunk over time.
Checkable deposits are payable on demand; that is, if a depositor shows
up at the bank and requests payment by making a withdrawal, the bank
will pay the depositor immediately. Similarly, if a person receives a check
written on an account from a bank, when the bank is presented with the
check, it must transfer funds immediately to that person's account.
A checkable deposit is an asset for the depositor because it is part of
his wealth. Conversely, because the depositor can withdraw funds from his
account that the bank is obligated to pay, checkable deposits are a liability
of the bank. They are usually'the lowest-cost source of bank funds because
depositors are willing to forgo some interest in order to have access to a
liquid asset that can be used to make purchases. The bank's costs of
maintaining checkable deposits include interest payments as well as the
costs incurred in servicing these accounts [processing and storing of can-
celed checks, preparing and sending out monthly statements, providing
efficient tellers (human or otherwise),maintaining an impressive building,
and advertisingmarketing to entice customers to deposit their funds with
a given bank]. In recent years interest paid on deposits (checkable and
time) have exceeded 50% of total bank operating expenses, while the costs
involved in servicing accounts (employee salaries, building rent, etc.1 have
been approximately 25% of operating expenses.

Nontransaction Deposits Nontransaction deposits are the primary

source of bank funds (48%of bank liabilities in Table 8.1).Characteristically,
they earn interest and do not allow their owner to write checks. Their
interest rates are usually higher than those on checking accounts because
the depositor is not provided with nearly as many services. There are three
basic types of nontransaction deposits: savings accounts, small-denomi-
nation time deposits (deposits of less than $100,000),.and large-denomi-
nation time deposits.
Savings accounts were once the most common type of nontransaction
 CHAPTER 8 The Banking Firm and Bank Management 165

deposit. In these accounts, to which funds can be added or withdrawn

any time, transactions and interest payments are recorded in a small book
(thepassbook) held by the owner of the account or in a monthly statement.
Technically, this form of deposit is not payable on demand (the bank can
wait up to thirty days to pay);however, because of competition for deposits,
banks allow depositors to make withdrawals from their savings accounts
without delay.
+, Small-denomination time deposits have a fixed maturity length ranging
from several months to over five years and have substantial penalties for
early withdrawal (the forfeit of several months' interest). Because time
deposits are less liquid for the depositor than passbook savings, they earn
higher interest rates and are a more costly source of funds for the banks.
Large-denomination time deposits (certificates of deposits, CDs) are
available in denominations of $100,000 or over and are typically bought by
corporations or other banks. Many large-denomination CDs are negotiable,
so that, like a bond, they can be resold in a secondary market before they
mature. For this reason, negotiable CDs are held by corporations, money
market mutual funds, and other financial institutions as alternative assets
to Treasury bills and other short-term bonds.

Borrowings Banks obtain funds by borrowing from the Federal Reserve

System, other banks, and corporations. Borrowings from the Fed are called
discount loans (also known as an "advance"),Banks also borrow reserves
overnight in the federal (Fed) funds market from other U.S. banks and
financial institutions. Other sources of borrowed funds are loans made to
banks by their parent companies (bank holding companies),loan arrange-
ments with corporations (such as repurchase agreements),and borrowings
of Eurodollars (deposits denominated in U.S. dollars residing in foreign
banks or foreign branches of U.S. banks).Borrowings have become a more
important source of bank funds over time: In 1960, they comprised only
2% of bank liabilities, while currently they exceed 20% of bank liabilities.

Bank Capital The final category on the liabilities side of the balance
sheet is bank capital, the bank's net wealth, which equals the difference
between total assets and liabilities (7% of total bank assets in Table 8.1).
The funds are raised by selling new equity (stock)or from retained earnings.
Bank capital is a cushion against a drop in the value of its assets, which
could force the bank into insolvency (where the value of bank assets falls
below its liabilities so that the bank is bankrupt).One important component
of bank capital is loan loss reserves which are described in Box 8.1.

Assets
The assets of a bank constitute the uses of bank funds. The income-earning
assets, which yield interest payments, enable banks to make profits.
PART 111 Financial Institutions

O t h e r A s s e t s The physical capital (bank buildings, computers, and

other equipment) owned by the banks are included in this category.

THE BASIC OPERATION OF A BANK

Before proceeding to more detailed study of how a bank manages its assets
and liabilities in order to make the highest profit, you should understand
the basic operation of a bank.
In general terms, banks make profits by selling liabilities with one set
of characteristics (a particular combination of liquidity, risk, and return)
and using the proceeds to buy assets with a different set of characteristics.
Banks thus provide a service to the public of transforming one type of asset
into another. Instead of making a mortgage loan to a neighbor, a person
can hold a savings deposit that enables a bank to make the loan to the
neighbor. The bank has, in effect, transformed the mortgage loan into a
savings deposit.
The process of transforming assets and providing a set of services
(check clearing, record keeping, and credit analysis, etc.) is like any other
production process in a business firm. If the bank produces desirable
services at low cost and earns substantial income on its assets, then it
earns profits; if not, the bank suffers losses.
To make our analysis of the operation of a bank more concrete, we
will use a tool called a T-account.A T-account is a simplified balance sheet
(which looks like a TI that only lists the changes that occur in balance
sheet items starting from some initial balance sheet position. Let's say, for
example, that Jane Brown has heard that the First National Bank provides
excellent service, and she opens a checking account with a $100 bill. She
now has a $100 checkable deposit at the bank, which shows up as a $100
liability in the bank's balance sheet. On the other hand, the bank now puts
her $100 bill into its vault so that the bank's assets rise by the $100 increase
in vault cash. The T-account for the bank looks as follows:
First National Bank
Assets Liabilities
Vault cash + $100 1 Checkable deposits + $100
Since vault cash is also part of the bank's reserves, we can rewrite the T-
account as follows:
Assets Liabilities
Reserves + $100 Checkable deposits + $100
Note that Jane Brown's opening of a checking account leads to an increase
in the bank's reserves equal to the increase in checkable deposits.
CHAPTER 8 The Banking Finn and Bank Management 169

If Jane had opened her account with a $100 check written from an
account at another bank, say, the Second National Bank of Utah, we would
get the same result. The initial effect on the T-account of the First National
Bank is as follows:

Assets Liabilities
Cash items in process of Checkable deposits + $100
collection + $100
Checkable deposits increase by $100 as before, but now the First National
Bank is owed $100 by the Second National Bank. This asset for the First
National Bank is entered in the T-account as $100 of "cash items in process
of collection" because the First National Bank will now try to collect the
funds that it is owed. It could go directly to the Second National Bank and
ask for payment of the funds, but if the two banks are in separate states,
this would be a time-consuming and costly process. Instead, the First
National Bank deposits the check in its account at the Fed, and the Fed
collects the funds from the Second National Bank. The result is that the
Fed transfers $100 of reserves from the Second National Bank to the First
National Bank, and the final balance sheet positions of the two banks are
as follows:

First National Bank Second National Bank

Assets Liabilities Assets Liabilities
Reserves + $100 Checkable Reserves - $100 Checkable
deposits + $100 deposits - $100

The process initiated by Jane Brown can be summarized as follows: When

a check written on an account at one bank is deposited in another, the
bank receiving the deposit gains reserves equal to the amount of the check,
while the bank on which the check is written sees its reserves fall by the
same amount. Therefore, when a bank receives additional deposits, it
gains an equal amount of reserves; when it loses deposits, it loses an
equal amount of reserves.
264 PART IV The Money Supply Process

it had no excess reserves. We begin the analysis with the following T-

account:
First National Bank
Assets Liabilities
Reserves + $100 Discount loan from
the Fed + $100
Because the bank has no increase in its checkable deposits, required re-
serves remain the same and the bank finds that its additional $100 of
reserves means that its excess reserves have increased by $100. Let's say
the bank decides to make a loan equal in amount to the $100 increase in
excess reserves. When the bank makes the loan, it sets up a checking
account for the borrower and puts the proceeds of the loan into this
account. In this way the bank alters its balance sheet by increasing its
liabilities with $100 of checkable deposits and at the same time increasing
its assets with the $100 loan. The resulting T-account follows:
First National Bank
Assets Liabilities
Reserves + $100 Discount loan from Fed 4- $100
Loans + $100 Checkable deposits + $100
The bank has created checkable deposits by its act of lending. Since check-
able deposits are part of the money supply, the bank's act of lending has
in fact created money.
With its current balance sheet position, the First National Bank still
has excess reserves that it could lend out. However, these reserves will not
stay at the bank for very long. The borrower took out a loan, not to leave
$100 idle at the First National Bank, but to purchase goods and services
from other individuals and corporations. When the borrower makes these
purchases by writing checks, they will be deposited at other banks and the
$100 of reserves will leave the First National Bank. A bank cannot loan out
a greater amount than the ezcess reserves it has before it makes the
loan.
The final T-account of the First National Bank is
First National Bank
Assets Liabilities
Loans + $100 I Discount loan from Fed + $100
The increase in reserves of $100 has been converted into additional loans
of $100 at the First National Bank, plus an additional $100 of deposits that
have made their way to other banks. (All the checks written on account at
the First National Bank are deposited in banks rather than converted into
cash, because we are assuming the public does not want to hold any