Module 5
Bank Management Assignment
a. The Balance Sheet of Commercial Banks
To focus our discussion of depository institutions, we will concentrate on what
are called commercial banks. These institutions were established to provide banking
services to businesses, allowing them to deposit funds safely and borrow them when
necessary. Today, many commercial banks offer accounts and loans to individuals as
well. To understand the business of commercial banking, we’ll start by examining the
commercial bank’s balance sheet. Recall that a balance sheet is a list of a household’s
or firm’s assets and liabilities: the sources of its funds (liabilities) and the uses to
which those funds are put (assets). A bank’s balance sheet says that Total bank assets
= Total bank liabilities + Bank capital (1) Banks obtain their funds from individual
depositors and businesses, as well as by borrowing from other financial institutions
and through the financial markets. They use these funds to make loans, purchase
marketable securities, and hold cash. The difference between a bank’s assets and
liabilities is the bank’s capital, or net worth— the value of the bank to its owners.
The bank’s profits come both from service fees and from the difference
between what the bank pays for its liabilities and the return it receives on its assets (a
topic we’ll return to later). Understanding the various revenue streams of a bank is
essential for grasping how these financial institutions operate and sustain their
profitability. Banks play a critical role in the financial system by acting as
intermediaries between savers and borrowers, and their ability to generate profit is
fundamental to their ongoing viability and capacity to provide services to their
customers.
Service fees represent one significant source of income for banks. These fees
can come from a variety of banking services provided to individual and business
customers. Common examples include monthly maintenance fees for checking and
savings accounts, overdraft fees when an account holder spends more than the
available balance, and ATM fees charged when using out-of-network machines.
Additionally, banks charge fees for specialized services such as wire transfers, safe
deposit box rentals, and cashier’s checks. Service fees can also extend to wealth
management and financial advisory services, where banks offer investment advice and
portfolio management for a fee.
Another major revenue stream for banks comes from the difference between
the interest they pay on their liabilities and the interest they earn on their assets, often
referred to as the net interest margin. Liabilities for a bank primarily consist of
customer deposits, such as savings accounts, checking accounts, and certificates of
deposit (CDs). The bank pays interest on these deposits to attract and retain
customers. For instance, a savings account might offer a modest interest rate to
incentivize individuals to deposit their money in the bank.
On the asset side, banks generate income by lending out the funds they have
gathered from deposits and other sources. These loans can take various forms,
including personal loans, mortgages, auto loans, business loans, and credit card
advances. The interest rates charged on these loans are generally higher than the rates
paid on deposits, creating a spread that contributes to the bank’s profits. For example,
while a bank might pay 1% interest on a savings account, it could charge 4% interest
on a mortgage, earning a 3% spread.
The composition of a bank’s loan portfolio can significantly impact its
profitability. Banks strive to balance risk and return by diversifying their loans across
different sectors and borrower types. They employ rigorous credit assessment
processes to evaluate the creditworthiness of borrowers, ensuring that the risk of
default is minimized. High-quality borrowers, such as those with strong credit
histories and stable incomes, typically receive lower interest rates, while riskier
borrowers might be charged higher rates to compensate for the increased risk.
In addition to traditional lending, banks invest in a variety of securities to
generate returns. These investments can include government and corporate bonds,
mortgage-backed securities, and other fixed-income instruments. The yields on these
securities contribute to the overall return on the bank’s assets. Banks also participate
in the interbank lending market, where they lend excess reserves to other banks,
earning interest in the process.
Banks often engage in off-balance-sheet activities to enhance profitability.
These activities include issuing letters of credit, providing loan commitments, and
engaging in derivatives trading. While these activities do not appear on the bank’s
balance sheet, they can generate significant fee income and affect the bank’s risk
profile. For example, a bank might earn fees for guaranteeing a company’s payment
obligations through a letter of credit, or it might generate income from trading
derivatives to hedge against interest rate fluctuations.
Investment banking and capital markets activities also contribute to a bank’s
revenue. Many banks have investment banking divisions that assist companies in
raising capital by underwriting new stock or bond issues. They also provide advisory
services for mergers and acquisitions, earning substantial fees for their expertise and
facilitation of complex transactions. Additionally, banks engage in proprietary trading,
where they trade securities for their own accounts to profit from market movements.
International operations can be another significant revenue source for banks,
especially those with a global presence. By operating in multiple countries, banks can
diversify their income streams and take advantage of growth opportunities in
emerging markets. Foreign exchange trading, international payment services, and
cross-border lending are examples of activities that generate income in the global
arena. Additionally, banks can benefit from favorable regulatory environments and
interest rate differentials between countries.
Banks also generate income through their wealth management and private
banking divisions. These divisions cater to high-net-worth individuals and
institutional clients, offering personalized financial planning, investment
management, and estate planning services. Fees for these services can be substantial,
reflecting the specialized expertise and tailored solutions provided to affluent clients.
Wealth management services help banks build long-term relationships with clients,
leading to steady fee income and opportunities for cross-selling other banking
products.
Another important aspect of a bank’s profitability is its ability to manage
operational costs efficiently. Banks invest heavily in technology and infrastructure to
streamline operations, enhance customer service, and reduce costs. Online and mobile
banking platforms, automated teller machines (ATMs), and digital payment systems
are examples of technological advancements that improve efficiency and convenience
for customers. Effective cost management allows banks to maximize their net interest
margin and overall profitability.
Regulatory compliance and risk management are critical factors that influence
a bank’s financial performance. Banks operate in a highly regulated environment,
with stringent requirements for capital adequacy, liquidity, and risk management.
Compliance with these regulations ensures the stability and soundness of the banking
system but also imposes costs on banks. Effective risk management practices,
including robust internal controls and stress testing, help banks navigate economic
uncertainties and mitigate potential losses, contributing to their long-term
profitability.
In conclusion, the bank’s profits come from a diverse range of sources,
including service fees and the net interest margin between liabilities and assets. By
offering a variety of services and products, managing risks effectively, and leveraging
technology, banks can maintain their profitability and continue to play a vital role in
the financial system. Their ability to balance risk and return, diversify income
streams, and adapt to changing market conditions is essential for their success and
sustainability in a competitive and dynamic environment.
Let’s start with the asset side of the balance sheet—what banks do with the
funds they raise. More than 20 percent of assets, or $3.5 trillion, is held in the form of
securities; 56 percent ($9.6 trillion) in the form of loans; and the remaining 23Apercent
in the form of cash and “Other assets.” The last category includes mostly buildings
and equipment, as well as collateral repossessed from borrowers who defaulted. In
looking at consolidated figures we can get some sense of their scale by comparing
them to nominal GDP. In the fourth quarter of 2018, U.S. nominal GDP was
$20.9Atrillion, so total bank assets were equivalent to more than 80Apercent of one
year’s GDP.
Cash assets are of three types. The first and most important is reserves. Banks
hold reserves because regulations require it and because prudent business practice
dictates it. Reserves include the cash in the bank’s vault (and the currency in its
ATMs), called vault cash, as well as the bank’s deposits at the Federal Reserve
System. Cash is the most liquid of the bank’s assets; the bank holds it to meet
customers’ withdrawal requests. Cash items also include what are called cash items in
process of collection. When you deposit your paycheck into your checking account,
several days may pass before your bank can collect the funds from your employer’s
bank. In the meantime, the uncollected funds are considered your bank’s asset because
the bank is expecting to receive them.
Finally, cash includes the balances of the accounts that banks hold at other
banks. In the same way that individuals have checking accounts at the local bank,
small banks have deposit accounts at large banks, and those accounts are classified as
cash. Over the years, the practice of holding such accounts has declined, so the total
quantity of these correspondent bank deposits has shrunk. In December 2018, banks
held more than 11Apercent of their assets in cash. Up to the financial crisis of 2007–
2009, that share was much smaller. Banks usually try to minimize their cash holdings
because they typically earn less interest than loans or securities. However, the crisis
forced them to change their strategy: A heightened possibility of bank runs, credit line
takedowns, and borrower defaults prompted them to scramble for liquidity, and as
market interest rates fell and the Federal Reserve began to pay interest on reserves,
the opportunity cost of holding cash plummeted.
The second-largest component of bank assets is marketable securities. While
banks in many countries can hold stock, U.S. banks cannot, so this category of assets
includes only bonds. Banks’ bond holdings are split between U.S. government and
agency securities, which account for 15.7Apercent of their assets, and other securities
(including state and local government bonds), which account for an additional 4.9A
percent.1 Note that more than half of all the securities are mortgage-backed
(11.0Apercent of assets). Nevertheless, a sizable proportion of the securities held by
banks are very liquid. They can be sold quickly if the bank needs cash, which makes
them a good backup for the bank’s cash balances. For this reason securities are
sometimes referred to as secondary reserves.
Loans are the primary asset of modern commercial banks, accounting for well
over one-half of assets. We can divide loans into five broad categories: business loans,
called commercial and industrial (C&I) loans; real estate loans, including both home
and commercial mortgages as well as home equity loans; consumer loans, like auto
loans and credit card loans; interbank loans (loans made from one bank to another);
and other types, including loans for the purchase of other securities. These types of
loans vary considerably in their liquidity. Some, like home mortgages and auto loans,
usually can be securitized and resold. Others, like small business loans, may be very
difficult to resell.
The primary difference among various kinds of depository institutions lies in
the composition of their loan portfolios, which reflects their distinct purposes,
clientele, and regulatory frameworks. Each type of institution—commercial banks,
savings and loan associations, and credit unions—serves unique roles within the
financial system, tailoring their services and loan products to meet the specific needs
of their respective customers.
Commercial banks are the most prevalent type of depository institution and
play a pivotal role in the economy by providing a wide range of financial services to
individuals, businesses, and governments. One of their primary functions is to make
loans to businesses, which can include small enterprises, medium-sized firms, and
large corporations. These loans can take various forms, such as working capital loans,
term loans, and commercial real estate loans. Working capital loans help businesses
manage their daily operations and cash flow needs, while term loans provide funds for
capital investments like purchasing equipment or expanding facilities. Commercial
real estate loans enable businesses to acquire or develop properties for operational
use.
In addition to business lending, commercial banks offer a broad spectrum of
consumer banking services. They provide personal loans, auto loans, and credit cards
to individual customers, addressing their diverse financial needs. Personal loans can
be used for various purposes, such as debt consolidation, home improvement, or
major purchases. Auto loans help individuals finance the purchase of new or used
vehicles, and credit cards offer a convenient way to manage short-term financing and
earn rewards. Despite their broad service offerings, the primary focus of commercial
banks remains on business lending, which forms a significant portion of their loan
portfolios.
Savings and loan associations (S&Ls), also known as thrifts, have a different
focus compared to commercial banks. These institutions were originally established to
promote homeownership by providing affordable mortgage financing to individuals.
As such, the bulk of their loan portfolios consists of residential mortgages. S&Ls offer
various types of mortgage loans, including fixed-rate mortgages, adjustable-rate
mortgages, and government-backed loans such as FHA and VA loans. These
institutions specialize in helping individuals purchase homes, refinance existing
mortgages, and access home equity through home equity loans or lines of credit.
In addition to residential mortgages, savings and loans may also offer other
consumer lending products, although to a lesser extent than commercial banks. For
example, they might provide personal loans, auto loans, and small business loans.
However, their core mission and expertise lie in mortgage lending, making them a
critical component of the housing finance system. By focusing on residential lending,
S&Ls contribute to the stability and accessibility of the housing market, enabling
more individuals to achieve homeownership.
Credit unions, on the other hand, are member-owned financial cooperatives
that prioritize serving their members' financial needs. Unlike commercial banks and
savings and loans, credit unions do not operate for profit. Instead, they aim to provide
affordable and accessible financial services to their members, who share a common
bond, such as working for the same employer, belonging to the same organization, or
residing in the same community. The loan portfolios of credit unions are heavily
geared toward consumer lending, reflecting their commitment to supporting their
members' personal financial goals.
Credit unions specialize in offering consumer loans, including personal loans,
auto loans, and credit cards. Personal loans from credit unions often come with lower
interest rates and more flexible terms compared to those offered by commercial banks,
making them an attractive option for members. Auto loans are a significant
component of credit unions' loan portfolios, providing members with financing
options for purchasing new or used vehicles. Credit unions also issue credit cards with
competitive rates and rewards programs, helping members manage their day-to-day
expenses and build credit.
In addition to consumer loans, credit unions offer mortgage loans, home
equity loans, and lines of credit, similar to savings and loans. However, their approach
to mortgage lending is often more personalized and member-centric, with an emphasis
on providing financial education and support throughout the homebuying process.
Credit unions may also offer small business loans to support local entrepreneurs and
small business owners within their membership base, fostering economic growth
within the community.
The regulatory environment for each type of depository institution further
shapes their operations and loan portfolios. Commercial banks are typically regulated
by federal and state banking authorities, such as the Office of the Comptroller of the
Currency (OCC), the Federal Reserve, and state banking departments. These
regulations ensure that commercial banks maintain adequate capital levels, manage
risks effectively, and operate in a safe and sound manner.
Savings and loan associations are regulated by the Office of the Comptroller
of the Currency (OCC) at the federal level, while state-chartered S&Ls are overseen
by state regulatory agencies. These regulations focus on ensuring the safety and
soundness of S&Ls, particularly in their mortgage lending activities, to protect
consumers and promote stability in the housing market.
Credit unions are regulated by the National Credit Union Administration
(NCUA) for federally chartered credit unions, while state-chartered credit unions are
overseen by state regulatory agencies. The cooperative nature of credit unions and
their focus on member service are reflected in their regulatory framework, which
emphasizes member protection, financial stability, and community development.
In conclusion, the primary difference among various kinds of depository
institutions lies in the composition of their loan portfolios, driven by their distinct
purposes, customer bases, and regulatory environments. Commercial banks focus on
business lending while also offering a wide range of consumer banking services.
Savings and loan associations specialize in residential mortgage lending, supporting
homeownership and housing market stability. Credit unions prioritize consumer loans,
providing personalized and member-centric financial services. Each type of institution
plays a unique and vital role in the financial system, contributing to the overall
diversity, stability, and accessibility of financial services for individuals and
businesses alike.
First, the rise of the commercial paper market made securities market debt
finance more convenient for large firms, which reduced the quantity of commercial
and industrial loans demanded. Second, the creation of mortgage-backed securities
(MBS) meant that banks could sell the mortgage loans they had made. This
innovation reduced the risk associated with an illiquid asset, encouraging banks to
move into the business of home lending. So, on top of making more real estate loans,
banks also acquired MBS, which recently accounted for more then half of securities
held. Since the crisis, however, banks appear to have reduced their overall real estate
exposure, underscoring the critical role that housing prices and MBS played in the
2007–2009 episode.
To finance their operations, banks need funds. They get them from savers and
from borrowing in the financial markets. To entice individuals and businesses to place
their funds in the bank, institutions offer a range of deposit accounts that provide
safekeeping and accounting services, access to the payments system, liquidity, and
diversification of risk, as well as interest payments on the balance. There are two
types of deposit accounts, transaction and nontransaction accounts. Transaction
accounts are known as checkable deposits. As of December 2018, checkable deposits
totaled $2.12Atrillion, or roughly 17Apercent of total deposits in the commercial
banking system.
“Demand deposits,” which allow a customer to withdraw funds without notice
on a first-come, first-served basis, make up the largest component of checkable
deposits. Banks also offer customers a variety of similar options that fall into the
category of checking accounts, such as insured market rate accounts. A typical bank
will offer half a dozen or more of these, each with slightly different characteristics. In
addition to the names created by banks’ marketing departments, economists use
various other terms in speaking of checkable deposits. For example, some economists
call them “sight deposits” because a depositor can show up to withdraw them when
the bank is in sight.
Over the years, financial innovation has reduced the importance of checkable
deposits in the day-to-day business of banking. As a share of total liabilities,
checkable deposits plummeted from 40 percent in the 1970s to about 14 percent at the
end of 2018. The reason for their decline is that checking accounts pay little or no
interest; they are a low-cost source of funds for banks but a low-return investment for
depositors. As interest rates rose through the 1970s and remained high into the 1990s,
individuals and businesses realized the benefits of reducing the balances in their
checking accounts and began to look for ways to earn higher interest rates. Banks
obliged by offering innovative accounts whose balances could be shifted
automatically when the customers’ checking accounts ran low.2 Thus, traditional
checking accounts are no longer the principal source of bank funds.
In December 2018, nontransaction deposits, including savings and time
deposits, accounted for more than half of all commercial bank liabilities. Savings
deposits, commonly known as passbook savings accounts, were popular for many
decades, though they are less so today. Time deposits are certificates of deposit (CDs)
with a fixed maturity. When you place your savings in a CD at your local bank, it is as
if you are buying a bond issued by that bank. But unlike government or corporate
bonds, there isn’t much of a resale market for your small CD. So if you want to
withdraw your funds before the CD matures, you must get them back from the bank.
To discourage early withdrawals, banks charge a significant penalty.
Certificates of deposit come in two varieties: small and large. Small CDs are
issued for $100,000 or less; large certificates of deposit exceed $100,000 in face
value. Large CDs are negotiable, which means that they can be bought and sold in the
financial markets, just like bonds and commercial paper. Investors in this wholesale
money market include corporate treasurers and others with large cash balances to
manage. Because large CDs can be resold, they have become an important source of
bank financing. When a bank needs funds, it can issue large CDs, in addition to
commercial paper and more conventional bonds.
Borrowing is the second most important source of bank funds. Today,
borrowings account for about 13Apercent of bank liabilities. Banks borrow in a
number of ways. First, they can borrow from the Federal Reserve. We’ll have much
more to say about such discount loans in Part IV. For now, think of this source of
funds as borrowing from the government. More often, banks borrow from other
intermediaries. For example, banks with excess reserves can lend their surplus funds
to banks that need them through an interbank market called the federal funds market.
Loans made in the federal funds market are unsecured—they lack collateral—so the
lending bank must trust the borrowing bank. These uncollateralized loans have
become very small, while collateralized bank loans and borrowings have grown.
Some of these borrowings come from foreign banks and from U.S.
government-sponsored enterprises (GSEs) that hold deposits at the Federal Reserve.
The sources and mechanisms of these borrowings are varied and complex, reflecting
the interconnectedness of the global financial system and the pivotal role of the
Federal Reserve as a central institution within it. Understanding the nuances of these
borrowing relationships provides insight into the broader dynamics of international
finance and the operational strategies of GSEs and foreign banks.
Foreign banks operating in the United States often engage in borrowing
activities to meet their liquidity needs and to manage their asset-liability mismatches.
These institutions maintain deposits at the Federal Reserve and participate in the U.S.
financial markets to diversify their funding sources, manage risks, and take advantage
of opportunities in one of the world's largest and most liquid financial markets. The
borrowing practices of foreign banks can include accessing the Federal Reserve's
discount window, participating in repurchase agreements (repos), and engaging in
interbank lending.
The discount window is a key tool that the Federal Reserve offers to eligible
depository institutions, including foreign banks, to borrow short-term funds to meet
temporary liquidity needs. By accessing the discount window, foreign banks can
ensure they have sufficient reserves to manage day-to-day operations and address any
unexpected cash flow challenges. The terms and conditions of discount window loans
are designed to provide a reliable backstop for institutions facing short-term liquidity
pressures while maintaining financial stability.
Repurchase agreements, or repos, are another important borrowing mechanism
used by foreign banks. In a repo transaction, a bank sells securities to another party
with an agreement to repurchase them at a later date, usually at a higher price. This
arrangement functions as a short-term loan, with the securities serving as collateral.
Foreign banks participate in the repo market to obtain short-term funding, manage
liquidity, and leverage their holdings of high-quality collateral. The Federal Reserve
itself is an active participant in the repo market, conducting operations to influence
short-term interest rates and ensure smooth functioning of financial markets.
Interbank lending is yet another avenue through which foreign banks can
secure funds. This market involves banks lending to one another on an unsecured
basis, typically for very short durations. Rates in the interbank lending market, such as
the London Interbank Offered Rate (LIBOR) or its successor rates, serve as important
benchmarks for a wide range of financial instruments. Foreign banks tap into the
interbank market to manage their liquidity positions, optimize their funding costs, and
balance their balance sheets.
U.S. government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie
Mac, and the Federal Home Loan Banks, also play a significant role in the borrowing
landscape. These institutions are established to support specific sectors of the
economy, primarily housing finance, and they maintain deposits at the Federal
Reserve as part of their operational and liquidity management strategies. GSEs issue
various forms of debt to finance their activities, including mortgage-backed securities
(MBS) and other debt instruments. They hold substantial amounts of cash and liquid
assets, which they deposit at the Federal Reserve to earn interest and ensure liquidity.
The borrowing activities of GSEs are closely linked to their mission of
promoting homeownership and affordable housing. For instance, Fannie Mae and
Freddie Mac purchase mortgages from lenders, providing them with liquidity to issue
more loans. These mortgages are then securitized into MBS, which are sold to
investors. The proceeds from these sales are used to finance further mortgage
purchases, creating a continuous cycle of liquidity and support for the housing market.
To manage their short-term funding needs and operational cash flows, GSEs may
borrow in the repo market or issue short-term debt securities, leveraging their deposits
at the Federal Reserve.
The Federal Home Loan Banks (FHLBanks) operate a cooperative system that
provides funding to member institutions, such as commercial banks, thrifts, and credit
unions, to support housing finance and community development. FHLBanks issue
consolidated obligations, including bonds and discount notes, to raise funds. These
obligations are backed by the collateral provided by member institutions, primarily in
the form of residential mortgages and other high-quality assets. The FHLBanks use
the proceeds to make advances (loans) to their members, helping them manage
liquidity and support lending activities.
The interaction between the Federal Reserve, foreign banks, and GSEs
highlights the complexity and interconnectedness of the financial system. The Federal
Reserve plays a crucial role in ensuring liquidity and stability by providing a safe and
secure repository for deposits, facilitating borrowing through various mechanisms,
and conducting monetary policy operations that influence interest rates and credit
conditions. The presence of foreign banks and GSEs in the U.S. financial markets
underscores the global nature of finance and the critical role that U.S. financial
infrastructure plays in supporting both domestic and international economic activities.
In conclusion, some of these borrowings come from foreign banks and from
U.S. government-sponsored enterprises that hold deposits at the Federal Reserve.
Foreign banks borrow to manage liquidity, leverage collateral, and participate in the
U.S. financial markets, utilizing tools such as the discount window, repos, and
interbank lending. GSEs borrow to support their missions in housing finance, issuing
various debt instruments and managing liquidity through deposits at the Federal
Reserve. The interconnectedness of these entities and their reliance on the Federal
Reserve underscore the centrality of the Federal Reserve in the global financial
system and its role in maintaining liquidity and stability across various sectors of the
economy.
Finally, banks borrow using an instrument called a repurchase agreement, or
repo, a short-term collateralized loan in which a security is exchanged for cash, with
the agreement that the parties will reverse the transaction on a specific future date,
typically the next day. For example, a bank that has a U.S. Treasury bill might need
cash, while a pension fund might have cash that it doesn’t need overnight. Through a
repo, the bank would give the T-bill to the pension fund in exchange for cash,
agreeing to buy it back—repurchase it—with interest the next day. In short, the bank
gets an overnight loan and the pension fund gets some extra interest, along with the
protection provided by collateral.
Net worth equals assets minus liabilities, whether we are talking about an
individual’s net worth or a bank’s. In the case of banks, however, net worth is referred
to as bank capital, or equity capital. (Important tip: Do not confuse bank capital and
cash reserves. Capital appears on the liability side of the balance sheet, whereas
reserves are an asset.) If the bank’s owners sold all its assets (without taking a loss)
and used the proceeds to repay all the liabilities, capital is what would be left. 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 (the inability to repay debts
when a firm’s liabilities exceed its assets). An important component of bank capital is
loan loss reserves, an amount the bank sets aside to cover potential losses from
defaulted loans. At some point a bank gives up hope that a loan will be repaid and the
loan is written off, or erased from the bank’s balance sheet. At that point the loan loss
reserve is reduced by the amount of the loan that has defaulted.
That $1.9 trillion of capital was combined with $15.1 trillion worth of
liabilities to purchase $17.0 trillion in assets. So the ratio of debt to equity in the U.S.
banking system was nearly 8 to 1. That’s a substantial amount of leverage, but it is
nearly 25Apercent below the average commercial bank debt-to-equity ratio that
prevailed prior to the financial crisis of 2007–2009. (Recall that the term leverage
refers to the portion of an asset that is purchased using borrowed funds.) To put this
ratio of 8 to 1 into perspective, we can compare it to the average debt-toequity ratio
for nonfinancial businesses in the United States, which is less than 1 to 1. Household
leverage is far lower, roughly 1/7 to 1.3 Recall from Tools that leverage increases both
risk and expected return. If you contribute half the purchase price of a house and
borrow the other half, both your risk and your expected return double. If you
contribute one-fifth of the purchase price and borrow the other four-fifths, your risk
and expected return go up by a factor of 5. So if a bank borrows $8 for each $1 in
capital, its risk and expected return increase a whopping 9Atimes! Banking, it seems, is
a very risky business, one of the explanations for the relatively high degree of
leverage in banking is the existence of government guarantees like deposit insurance,
which allow banks to capture the benefits of risk taking without subjecting depositors
to potential losses.
For a typical U.S. bank, prior to the financial crisis of 2007–2009, the return
on assets was about 1.3 percent, while the return on equity was 10 to 12 times that
high. For large banks, the return on equity tends to be higher than for small banks,
which suggests greater leverage, a riskier mix of assets, or the existence of significant
economies of scale in banking. The poor performance of many large banks in the
crisis, combined with moderate returns in its aftermath, suggests that their precrisis
higher returns (compared to small banks) at least partly reflected more leverage or a
riskier asset mix. Nevertheless, research also points to sizable economies of scale for
banks with assets exceeding $100 billion.
Before continuing, it is important to introduce one more measure of bank
profitability: net interest income. This measure is related to the fact that banks pay
interest on their liabilities, creating interest expenses, and receive interest on their
assets, creating interest income. Deposits and bank borrowing create interest
expenses; securities and loans generate interest income. The difference between the
two is the bank’s net interest income. Net interest income can also be expressed as a
percentage of total assets to yield a quantity called net interest margin. This is the
bank’s interest rate spread, which is the (weighted) average difference between the
interest rate received on assets and the interest rate paid for liabilities. A bank’s net
interest margin is closely related to its return on assets. Just take the bank’s fee
income minus its operating costs, divide by total assets, add the result to the net
interest margin, and you get its ROA. Roughly equivalent to a manufacturer or
retailer’s gross profits and gross profit margin, net interest income and net interest
margin reveal a great deal about a bank’s business.
A financial firm’s balance sheet provides only so much information. To
generate fees, banks engage in numerous off-balance-sheet activities. Recall that
banks exist to reduce transactions costs and information costs as well as to transfer
risks. When they perform these services, bankers expect to be compensated. Yet many
of these activities do not appear as either assets or liabilities on the bank’s balance
sheet, even though they may represent an important part of a bank’s profits and may
add significantly to the risks that a bank faces. For example, banks often provide
trusted customers with lines of credit, which are similar to the credit limits on credit
cards. The firm pays the bank a fee in return for the ability to borrow whenever
necessary. When the agreement is signed, the bank receives the payment and the firm
receives a loan commitment. However, not until a loan has actually been made—until
the firm has drawn down the credit line—does the transaction appear on the bank’s
balance sheet.
In the meantime, the bank is compensated for reducing both transactions and
information costs. Without the loan commitment, the firm would find credit difficult
and potentially expensive to obtain on short notice (a transactions cost). And because
the bank usually knows the firms to which it grants lines of credit, the cost of
establishing their creditworthiness (an information cost) is negligible. Letters of credit
are another important off-balance-sheet item for banks. These letters guarantee that a
customer of the bank will be able to make a promised payment. For example, a U.S.
importer of television sets may need to reassure a Chinese exporter that the firm will
be able to pay for the imported goods when they arrive. This customer might request
that the bank send a commercial letter of credit to the Chinese exporter guaranteeing
payment for the goods on receipt. By issuing the letter of credit, the bank substitutes
its own guarantee for the U.S. importer’s credit risk, enabling the transaction to go
forward. In return for taking this risk, the bank receives a fee.
A related form of the letter of credit is called a standby letter of credit. These
letters, which are issued to firms and governments that wish to borrow in the financial
markets, are a form of insurance. Commercial paper, even when it is issued by a large,
well-known firm, must be backed by a standby letter of credit that promises the bank
will repay the lender should the issuer default. What is true for large corporations is
true for state and local governments as well: in most cases, they need a bank
guarantee to issue debt. As with loan commitments, letters of credit expose the bank
to risk in a way that is not readily apparent on the bank’s balance sheet. Because off-
balance-sheet activities create risk for financial institutions, they have come under
increasing scrutiny in recent years. While LTCM’s balance sheet carried assets worth
over $100 billion when the firm got into trouble, the risky instruments that did not
appear on its balance sheet—the $1.25 trillion in interest rate swaps— were what
scared everyone. A similar problem arose in the financial crisis of 2007–2009, when
the invisible, off-balance-sheet risks taken by some of the largest banks and other
intermediaries added to doubts about their solvency. By allowing for the transfer of
risk, modern financial instruments enable individual institutions to concentrate risk in
ways that are very difficult for outsiders to discern. When revealed, these hidden
attributes can undermine financial stability.
b. Bank Risk: Where It Comes from and What to Do about It
Banking is risky both because depository institutions are highly leveraged and
because of what they do. The bank’s goal is to make a profit in each of its lines of
business. Some of these are simply fee-for-service activities. For example, a financial
institution might act as a broker, buying and selling stocks and bonds on a customer’s
behalf and charging a fee in return. Banks also transform deposit liabilities into assets
such as loans and securities. In the process, they pool savings, provide liquidity
services, allow for diversification of risk, and capitalize on the advantages they have
in producing information. All along, the goal is to pay less for the deposits the bank
receives than for the loans it makes and the securities it buys. That is, the interest rate
the bank pays to attract liabilities must be lower than the return it receives on assets.
In the process of all these activities, the bank is exposed to a host of risks.
They include the chance that depositors will suddenly withdraw their balances, that
borrowers will not repay their loans, that interest rates will change, and that the bank’s
securities trading operation will do poorly. Each of these risks has a name: liquidity
risk, credit risk, interest rate risk, and trading risk. To understand how these risks arise
and what can be done about them, we will look at each in detail.
All financial institutions face the risk that their liabilities holders (depositors)
will seek to cash in their claims. The holder of a checking account can always take
cash out at an ATM or make a transfer to someone else via mobile phone or over the
Internet. This risk of a sudden demand for liquid funds is called liquidity risk. Banks
face liquidity risk on both sides of their balance sheets. Deposit withdrawal is a
liability-side risk, but there is an asset-side risk as well. Recall from our discussion of
off-balance-sheet activities that banks provide households and firms with lines of
credit—promises to make loans on demand. When this type of loan commitment is
claimed, or taken down, the bank must find the liquidity to cover it. If the bank cannot
meet customers’ requests for immediate funds, it runs the risk of failure. Even if a
bank has a positive net worth, illiquidity can still drive it out of business. Who would
put their funds in a bank that can’t always provide cash on demand? For this reason,
bankers must manage liquidity risk with great care. Failure to do so in the crisis of
2007–2009 led to bank runs—such as the run on Wachovia in SeptemberA2008—and
to the failures of numerous bank and nonbank intermediaries.
To fully understand liquidity risk and how banks manage it, let’s look at a
simplified balance sheet. Banking regulations require that banks hold a portion of
their assets either as vault cash or as deposits at the Fed. That portion is stated as a
specific percentage of the bank’s deposits. If we assume that required reserves are 10
percent of deposits, then the $100 million in deposits shown on the balance sheet
means that the bank is required to hold $10 million in reserves. The fact that the bank
is holding $15 million in reserves means that it has $5 million in excess reserves. To
assess liquidity risk, we need to ask how the bank will handle a customer’s demand
for funds. What happens if a corporate customer arrives at the bank and requests a
withdrawal of $5 million? Because the bank has $5 million in excess reserves, it can
honor the customer’s request immediately, without difficulty. Similarly, if the bank
were forced suddenly to honor a $5 million loan commitment, it could do so by
drawing down its reserves. In the past, this was a common way to manage liquidity
risk; banks would simply hold sufficient excess reserves to accommodate customers’
withdrawals. This is a passive way to manage liquidity risk.
The problem is, holding excess reserves is expensive, because it means
forgoing the higher rate of interest that typically can be earned on loans or securities.
Banks work hard to find other ways to manage the risk of sudden withdrawals and
drawdowns of loan commitments. There are two other ways to manage the risk that
customers will require cash: This bank has $10 million in reserves to back its $100
million in deposits, so it has no excess reserves. If a customer makes a $5 million
withdrawal, the bank can’t simply deduct it from reserves. Instead, the bank will need
to adjust another part of its balance sheet.5 This bank has two choices in responding
to the shortfall created by the $5 million withdrawal: It can adjust either its assets or
its liabilities. On the asset side, the bank has several options. The quickest and easiest
one is to sell a portion of its securities portfolio. Because some of them are almost
surely U.S. Treasury securities, they can be sold quickly and easily at relatively low
cost. Note that assets and liabilities are both $5 million lower than they were prior to
the withdrawal. Banks that are particularly concerned about liquidity risk can
structure their securities holdings to facilitate such sales.
A second possibility is for the bank to sell some of its loans to another bank.
While not all loans can be sold, some can. Banks generally make sure that a portion of
the loans they hold are marketable for just such purposes. Yet another way to handle
the bank’s need for liquidity is to refuse to renew a customer loan that has come due.
Corporate customers have short-term loans that are periodically renewed, so the bank
always has the option of refusing to extend the loan again for another week, month, or
year. But this course of action is not very appealing. Failing to renew a loan is
guaranteed to alienate the customer and could well drive the customer to another
bank. The idea is to separate good customers from bad ones and develop long-term
relationships with the good ones. The last thing a bank wants to do is to refuse a loan
to a creditworthy customer it has gone to some trouble and expense to find.
Moreover, bankers do not like to meet their deposit outflows by contracting
the asset side of the balance sheet because doing so shrinks the size of the bank. And
because banks make a profit by turning liabilities into assets, the smaller their balance
sheets, the lower their profits. For this reason alone, today’s bankers prefer to use
liability management to address liquidity risk. That is, instead of selling assets in
response to a deposit withdrawal, they find other sources of funds. There are two
ways for banks to obtain additional funds. First, they can borrow to meet the shortfall,
either from the Federal Reserve or from another bank.
A second way to adjust liabilities in response to a deposit outflow is to attract
additional deposits. The most common way to do so is to issue large-denomination
CDs (with a value over $100,000), effectively borrowing in the wholesale money
market, these nontransaction deposits are combined with checking accounts. As we
saw earlier, large certificates of deposit have become an increasingly important source
of funds for banks. Now we know why: It is because they allow banks to manage their
liquidity risk without changing the asset side of their balance sheets. In the crisis of
2007–2009, many of the usual mechanisms for managing liquidity risk failed. Banks
could neither sell their illiquid assets nor obtain at a reasonable cost the funding
needed to hold those assets. The sudden and unanticipated loss of both market and
funding liquidity threatened the financial system as a whole.
Banks profit from the difference between the interest rate they pay to
depositors and the interest rate they receive from borrowers. That is, the return on
their assets exceeds the cost of their liabilities. At least, that’s the idea. But to ensure
that this profit-making process works, for the bank to make a profit, borrowers must
repay their loans. There is always some risk that they won’t. The risk that a bank’s
loans will not be repaid is called credit risk. To manage their credit risk, banks use a
variety of tools. The most basic are diversification, in which the bank makes a variety
of different loans to spread the risk, and credit risk analysis, in which the bank
examines the borrower’s credit history to determine the appropriate interest rate to
charge. Diversification means spreading risk, which can be difficult for banks,
especially those that focus on certain kinds of lending. Because banks specialize in
information gathering, it is tempting to try to gain a competitive advantage in a
narrow line of business. The problem is, if a bank lends in only one geographic area
or only one industry, it exposes itself to economic downturns that are local or
industry-specific. It is important that banks find a way to hedge such risks.
There we saw that rating agencies like Moody’s and Standard & Poor’s
produce letter ratings for large corporations wishing to issue bonds. Banks do the
same for small firms wishing to borrow, and specialized firms gather information
about the credit history of individual borrowers. Credit risk analysis uses a
combination of statistical models and information that is specific to the loan applicant.
The result is an assessment of the likelihood that a particular borrower will default.
When the bank’s loan officers decide to make a loan, they use the customer’s credit
rating to determine how high an interest rate to charge. To the interest rate they must
pay on their liabilities, they add a markup that will allow them to make a profit. The
poorer a borrower’s credit rating, the higher the interest rate they will charge.7 In the
crisis of 2007–2009, many banks seriously underestimated the risks associated with
mortgage and other household credit. They had not anticipated the first decline of
nationwide housing prices since the Great Depression or the surge of unemployment
to double-digit rates. As a consequence, they overestimated the value of the collateral.
Rising defaults prompted large losses and impaired their capital, although not as much
as crisis-driven trading losses on mortgage-backed and related securities.
Because banks are in the business of turning deposit liabilities into loan assets,
the two sides of their balance sheet do not match up. One important difference is that
a bank’s liabilities tend to be short term, while its assets tend to be long term. This
mismatch between the maturities of the two sides of the balance sheet creates interest
rate risk. To understand the problem, think of both the bank’s assets and its liabilities
as bonds. That is, the bank’s deposit liabilities are just like bonds, as are its loan
assets. (The bank must have some capital as well.) We know that a change in interest
rates will affect the value of a bond; when interest rates rise, the price of a bond falls.
More important, the longer the term of the bond is, the greater the change in the
bond’s price at any given change in the interest rate. Thus, when interest rates rise,
banks face the risk that the value of their assets will fall more than the value of their
liabilities (reducing the bank’s capital). Put another way, if a bank makes long-term
loans, it receives payments from borrowers that do not vary with the interest rate. But
its short-term liabilities—those with variable interest rates—require the bank to make
larger payments when interest rates rise. So rising interest rates reduce revenues
relative to expenses, directly lowering the bank’s profits.
The best way to see this point is to focus on a bank’s revenue and expenses.
Let’s start by dividing the bank’s assets and liabilities into two categories, those that
are interest rate sensitive and those that are not. The term interest rate sensitive means
that a change in interest rates will change the revenue produced by an asset. Because
newly purchased short-term bonds always reflect a change in interest rates, short-term
bonds that are constantly maturing and being replaced with new ones produce interest
rate sensitive revenue. In contrast, when the bank purchases long-term bonds, it
receives a fixed stream of revenue. Purchasing a 5 percent, 10-year bond means
getting $5 per $100 of face value for 10 years, regardless of what happens to
interestArates in the meantime. So the revenue stream from a long-term bond is not
interest rate sensitive. Suppose that 20 percent of a bank’s assets fall into the first
category, those that are sensitive to changes in the interest rate. Another 80 percent
fall into the second category, those that are not sensitive to changes in the interest rate.
If the interest rate has been stable at 5 percent for some time, then for each $100 in
assets, the bank receives $5 in interest. The bank’s liabilities tend to have a different
structure. Let’s assume that half the bank’s deposits are interest rate sensitive and half
are not. In other words, half the bank’s liabilities are deposits that earn variable
interest rates, so the costs associated with them move with the market rate. Interest-
bearing checking accounts fall into this category. The remainder of the bank’s
liabilities are time deposits such as certificates of deposit, which have fixed interest
rates. The payment a bank makes to the holder of an existing CD does not change
with the interest rate.
For the bank to make a profit, the interest rate on its liabilities must be lower
than the interest rate on its assets. The difference between the two rates is the bank’s
net interest margin. Assuming that the interest rate on its liabilities has been 3Apercent,
the bank has been paying out $3 per $100 in liabilities. Because the bank is receiving
5Apercent interest on its assets, its net interest margin is 2Apercent (5 minus 3). This
margin is the bank’s profit. Now look at what happens if interest rates rise 1 percent
for interest-sensitive assets and liabilities. For each $100 in assets, the bank’s revenue
goes up from (0.05A× $100)A= $5 to [(0.05 × $80) + (0.06 × $20)] = $5.20. But the
cost of its liabilities goes up too, from (0.03 × $100) = $3 to [(0.03 × $50) + (0.04 ×
$50)] = $3.50. So a one-percentage point rise in the interest rate reduces the bank’s
profit from ($5A−A$3)A= $2 per $100 in assets to ($5.20 − $3.50) = $1.70, a decline of
$0.30, or 15Apercent. This example illustrates a general principle: When a bank’s
liabilities are more interest rate sensitive than its assets are, an increase in interest
rates will cut into the bank’s profits.
The first step in managing interest rate risk is to determine how sensitive the
bank’s balance sheet is to a change in interest rates. Managers must compute an
estimate of the change in the bank’s profit for each one-percentage point change in the
interest rate. This procedure is called gap analysis, because it highlights the gap, or
difference, between the yield on interest rate sensitive assets and the yield on interest
rate sensitive liabilities. In our example, the asset-liability gap is (20 percent − 50
percent)A= −30. Multiplying this gap times the projected change in the interest rate
yields the change in the bank’s profit. A gap of −30 tells us that a one-percentage
point increase in the interest rate will reduce the bank’s profit by 30 cents per $100Ain
assets, which is the same answer we got in the last paragraph. Gap analysis can be
refined to take account of differences in the maturity of assets and liabilities, but the
analysis quickly becomes complicated.
Bank managers can use a number of tools to manage interest rate risk. The
simplest approach is to match the interest rate sensitivity of assets with the interest
rate sensitivity of liabilities. For instance, if the bank accepts a variable-rate deposit, it
then uses the funds to purchase short-term securities. A similar strategy is to make
longterm loans at a floating interest rate—as in adjustable-rate mortgages (ARMs)—
instead of at the fixed interest rate characteristic of a conventional mortgage. But
while this approach reduces interest rate risk, it increases credit risk. Rising interest
rates put additional strain on floating-rate borrowers, increasing the likelihood that
they will default on their payments. While restructuring assets to better match
liabilities can reduce risk, the fact that it also reduces potential profitability has led
bankers to look for other ways to control interest rate risk. Alternatives include the use
of derivatives, specifically interest rate swaps, to manage interest rate risk. For a bank
that is holding long-term assets and short-term liabilities, an interest rate swap is
exactly the sort ofA financial instrument that will transfer the risk of rising interest
rates to anotherAparty.
There was a time when banks merely took deposits and made loans, holding
them until they were completely paid off. Today, banks not only engage in
sophisticated asset and liability management but they hire traders to actively buy and
sell securities, loans, and derivatives using a portion of the bank’s capital, in the hope
of making additional profits for the bank’s owners. But trading financial instruments
is risky. If the price at which an instrument is purchased differs from the price at
which it is sold, the risk is that the instrument may go down in value rather than up.
This type of risk is called trading risk, or sometimes market risk. 9 Managing trading
risk is a major concern for today’s banks. Some of the largest banks in the world have
sustained billions of dollars in losses as a result of unsupervised risk taking by
employees in their trading operations. The problem is that traders normally share in
the profits from good investments, but the bank pays for the losses. Heads, the trader
wins; tails, the bank loses. This arrangement creates moral hazard: Traders have an
incentive to take more risk than bank managers would like.
Natural and human-made disasters highlight another set of risks that banks
face. Severe weather, such as Hurricane Sandy that flooded Manhattan in 2012 or
Hurricane Irma that paralyzed the Gulf Coast of Florida in 2017, raises questions
about the resilience of infrastructure. When terrorists attacked the World Trade Center
on September 11, 2001, they destroyed critical financial systems threatening to shut
down banks, ATMs, and credit card operations across the country.10 More recently,
the extraordinary data breach at Equifax, affecting 143 million people, highlights the
damage that hackers can wreck. These episodes emphasize the importance of
operational risk, defined as the risk of loss resulting from inadequate or failed internal
processes, people and systems. Addressing natural disasters is part of virtually every
large firm’s business continuity plans. To limit disruptions, some firms create backup
sites with duplicate infrastructure that is physically distant from the primary site.
Operational risk also includes cyber risk—the losses that arise when information
technology systems fail or are compromised. This encompasses a variety of risks,
some of which—like equipment failure—are increasingly addressed using “cloud
computing” and other redundant systems. At the top of the list today, however, are the
personal data breaches that are increasingly common, and especially likely to occur in
financial services. From 2005 to 2018, the Privacy Rights Clearinghouse reports
nearly 800 financial data breaches exposing 650 million records!
It’s not difficult to imagine why the financial sector is both vulnerable and a
target. Financial institutions, markets, and third-party vendors are especially reliant on
information and communication technology to supply instantaneous on-demand
services in large volumes at low cost. They have enormous client databases. They
form an extensive network—domestically and globally—through the payments
mechanism, exchanges, clearing and settlement systems, and the like. Cyberattackers
can and do seek out the weakest links in these chains in order to achieve their goals—
whether to steal property or, as may be the case with some hostile state actors, to
destroy it and undermine confidence. And, it is no mystery why they target data
related to finance. As bank robber Willie Sutton supposedly said, that’s where the
money is. The burden of protecting electronic records and networks falls on
individual firms. This creates a problem because of the potential for spillovers when
data breaches occur: If key personal identifiers can be used fraudulently, the entire
financial system may be at risk. Because firms cannot reap the full benefits of their
data security investments, they lack the incentive to ensure the socially optimal level
of cybersecurity or cyber resilience. Left on its own, the private market will
underinvest. This means that there is a role for government—in cooperation with the
private sector—in promoting cybersecurity.
What should the government do? One key role is to encourage disclosure and
information sharing. Firms have strong incentives—for legal and reputational reasons
—to conceal cyberattacks that successfully exploit their vulnerabilities. As a result, it
is widely believed that most events go unreported. The lack of reporting makes the
financial system even more vulnerable. First, firms find it difficult to manage rapidly
changing threats if they do not know the different types of attack that may occur, let
alone their probability. Second, concealment contributes to long lags in recognizing
ongoing attacks, allowing them to spread across vulnerable firms. As a result, it is
difficult or impossible to prevent contagion and reduce widespread damage. Third, the
lack of a sufficient data history means that it is impossible to build actuarial models
forApricing insurance against losses from cyberattack. Consequently, financial
institutions likely are underinsured against cyber risk.
The good news is that widespread public attention to these threats—along with
frequent, sizable losses—has prompted both firms and governments to promote
cybersafety. While spending is still relatively low—by one estimate financial
institutions spent $16 billion on cybersecurity in 2017—amounts are growing. In the
United States, firms also have formed associations (likeAFinancial Services
Information Sharing and Analysis Center [FS-ISAC]) to share insights and data, and
to establish reliable safety procedures in the event of infrastructure failures.AAnd,
together with the private sector, financial regulators have developed a range of
“tabletop exercises” in which authorities and bank managers come together to
simulate an emergency, thereby identifying vulnerabilities before hackers do so. The
challenge will be to keep up with the malicious actors. Financial firms are in anAarms
race. To stay competitive, firms and regulators will need to anticipate and focus onA
prospectiveA risks, rather than merely ensure compliance with rules that address past
incidents. Most important, they will need to avoid the kind of “failure of imagination”
that the 9/11 Commission cited as one of the key sources of U.S. vulnerability to that
attack. The rapid changes in both technology and the financial system bring not only
new opportunities, but the possibility for previously unimagined catastrophes as well.
If anything, the odds of disaster rise with the increased complexity and
interconnectedness of finance.
Beyond liquidity, credit, interest rate, trading, cyber, and operational risk,
banks face an assortment of other risks. A bank that operates internationally will face
foreign exchange risk and sovereign risk. Foreign exchange risk comes from holding
assets denominated in one currency and liabilities denominated in another. For
example, a U.S. bank that holds dollar-denominated liabilities might purchase bonds
issued by Sony Corporation or make a loan to a Japanese business. Both those assets
would be denominated in yen. Thus, when the dollar–yen exchange rate moves, the
dollar value of the bank’s assets will change. Banks manage their foreign exchange
risk in two ways. They work to attract deposits that are denominated in the same
currency as their loans, thereby matching their assets with their liabilities, and they
use foreign exchange futures and swaps to hedge the risk. But both approaches can
introduce other risks that need to be managed.
Sovereign risk arises from the fact that some foreign borrowers may not repay
their loans, not because they are unwilling to, but because their government prohibits
them from doing so. When a foreign country is experiencing a financial crisis, the
government may decide to restrict dollar-denominated payments, in which case a U.S.
bank would have difficulty collecting payments on its loans in the country. Such
circumstances have arisen on numerous occasions. Examples include Asia in 1997,
Russia in 1998, and Argentina in 2002. In all these cases governments and
corporations alike had difficulty raising enough dollars to repay their dollar-
denominated debts. In such crises, a bank has very little recourse in the courts and
little hope of recovering the loans. In 2011–2012, Europe’s sovereign debt crisis
prompted sufficient fear that some countries would give up the euro (and re-create
their own currencies) that many banks moved assets out of countries on the
geographic periphery of the euro area to avoid so-called redenomination risk. The
result was a capital flight that threatened the euro itself.
