© 2014 Pearson Education, Inc
© 2014 Pearson Education, Inc
© 2014 Pearson Education, Inc
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
•In 2012, despite record low mortgage interest rates, people had difficulty
in obtaining mortgage loans or refinancing old loans.
•Banks granted mortgages only to applicants with nearly perfect histories
and the willingness to make large down payments.
•Problems in the mortgage market reduced the effectiveness of the Fed’s
monetary policy, which aimed at increasing spending on goods and
services through lowering interesting rates.
• The key commercial banking activities are taking in deposits from savers and
making loans to households and firms.
• A bank’s primary sources of funds are deposits, and primary uses of funds
are loans, which are summarized in the bank’s balance sheet.
Bank capital is the difference between the value of a bank’s assets and the
value of its liabilities; also called shareholders’ equity.
Checkable Deposits
Reserves are bank assets consisting of vault cash plus bank deposits with the
Federal Reserve.
Vault cash is cash on hand in a bank (including currency in ATMs and deposits
with other banks).
Excess reserves are reserves banks hold above those necessary to meet
reserve requirements.
• Bank capital is the difference between the value of a bank’s assets and the
value of its liabilities.
• A bank’s capital represents the funds contributed by the bank’s shareholders
through their purchases of stock the bank has issued plus accumulated
retained profits.
• In 2012, bank capital was about 13% of bank assets for the U.S. banking
system as a whole.
• As the value of a bank’s assets or liabilities changes, so does the value of
the bank’s capital.
a. Use the entries to construct a balance sheet similar to the one in Table 10.1,
with assets on the left side of the balance sheet and liabilities and bank
capital on the right side.
b. The bank’s capital is what percentage of its assets?
The Basics of Commercial Banking: The Bank Balance Sheet
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Solved Problem 10.1 10.1
Constructing a Bank Balance Sheet
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by using the entries to construct the bank’s balance
sheet.
Wells Fargo uses its excess reserves to buy Treasury bills worth $30 and make
a loan worth $60.
The Basic Operations of a Commercial Bank
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Making the Connection
In Your Interest
Your Bank’s Message to You: “Please Go Away!”
• Your bank may well lose money on your checking account, which typically
costs about $300 a year to maintain.
• In addition to loaning out depositors’ money, banks traditionally earn income
from depositors by: (1) collecting fees from stores when debit cards are
used, (2) charging overdraft fees, and (3) collecting fees when depositors
purchase financial products.
• Dodd-Frank Act of 2012 placed limits on fees for debit cards and overdrafts.
• Banks have responded to the new regulations by closing branches in lower-
income neighborhoods, increasing their marketing of financial services to
higher-income customers, and raising minimum balance requirements.
Net interest margin is the difference between the interest a bank receives on
its securities and loans and the interest it pays on deposits and debt, divided by
the total value of its earning assets.
Return on assets (ROA) is the ratio of the value of a bank’s after-tax profit
to the value of its assets.
Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to
the value of its capital.
• ROA and ROE are related by the ratio of a bank’s assets to its capital:
Bank leverage is the ratio of the value of a bank’s assets to the value of its
capital.
Liquidity risk is the possibility that a bank may not be able to meet its cash
needs by selling assets or raising funds at a reasonable cost.
Credit risk is the risk that borrowers might default on their loans.
Diversification
• By diversifying, banks can reduce the credit risk associated with lending too
much to a single borrower.
Credit-risk analysis is the process that bank loan officers use to screen loan
applicants.
• Today, most banks charge rates that reflect changing market interest rates
instead of the prime rate.
Prime rate was formerly the interest rate banks charged on six-month loans to
high-quality borrowers (now an interest rate banks charge primarily to smaller
borrowers).
• Collateral is assets pledged to the bank in the event that the borrower
defaults.
• Good borrowers can obtain credit at a lower interest rate or with fewer
restrictions.
A rise (fall) in the market interest rate will lower (increase) the present value
of a bank’s assets and liabilities.
Gap analysis is an analysis of the gap between the dollar value of a bank’s
variable-rate assets and the dollar value of its variable-rate liabilities.
• an increase in market interest rates will reduce the value of the bank’s assets
more than the value of the bank’s liabilities, which will decrease the bank’s
capital.
The National Banking Act of 1863 made it possible for a bank to obtain a
federal charter.
Dual banking system is the system in the United States in which banks are
chartered by either a state government or the federal government.
• The Federal Reserve plays the role of a lender of last resort by making
discount loans to banks.
• Before the Fed existed, banks were subject to bank runs.
• If many banks simultaneously experienced runs, a bank panic often resulted
in banks being unable to return depositors’ money.
• After the severe bank panic of 1907, Congress passed the Federal Reserve
Act in 1913.
• The Great Depression led to bank panics, and Congress responded with the
creation of the Federal Deposit Insurance Corporation (FDIC) in 1934.
• In the early 1900s, banks were prohibited from crossing state lines.
• In 1900, only 87 of the 12,427 commercial banks in the United States
had any branches—unit banking.
• The U.S. system of many small, geographically limited banks failed to
take advantage of economies of scale in banking.
• Restrictions on branching within the state loosened after the mid-
1970s.
Off-Balance-Sheet Activities
2. Loan commitments.
Loan commitment is an agreement by a bank to provide a borrower with a
stated amount of funds during some specified period of time.
4. Trading activities.
• Banks earn fees from trading in the multibillion-dollar markets for futures,
options, and interest-rate swaps.
• Bank losses from trading in securities became a concern during the
financial crisis of 2007-2009.
Capital Purchase Program (CPP) is another initiative to inject capital into banks
by purchasing stock in hundreds of troubled banks.