Chapter 12
Depository Institutions:
Banks and Bank Management
Learning Objectives
After reading this chapter, you should be able to:
LO 1 Describe a commercial bank's assets and liabilities.
LO2 Define bank capital and key measures of bank profits and returns.
LO3 Identify the types and sources of bank risk and explain how to control them.
Banks are the most visible financial intermediaries in the economy. Most of us use the
word bank to describe what people in the financial world call depository institutions.
These are the financial institutions that accept deposits from savers and make loans to
borrowers. What distinguishes depository institutions from nondepository institutions is
their primary source of funds—that is, the liability side of their balance sheets. Depository
institutions include commercial banks, savings and loans, and credit unions—the financial
intermediaries most of us encounter in the course of our day-to-day lives.
Banking is a business. Actually, it’s a combination of businesses designed to deliver
the services discussed in Chapter 11. One business provides the accounting and recordkeeping
services that track the balances in your accounts. Another grants you access
to the payments system, allowing you to convert your account balances into cash or
transfer them to someone else. Yet a third business pools the savings of many small
depositors and uses them to make large loans to trustworthy borrowers. A fourth business
offers customers diversification services, buying and selling financial instruments
in the financial markets in an effort to make a profit. Banks trade in the financial
markets not just as a service to their customers but in an effort to earn a profit for their
owners as well.
The intent of banks, of course, is to profit from each of these lines of business.
Our objective in this chapter is to see how they do it. Not all banks make a profit.
While some banks are extremely large, with hundreds of billions of dollars in loans and
securities on their balance sheets, their access to funds is no guarantee of profitability.
The risk that banks may fail is a problem not just for their owners and managers but
for the rest of us, too. In the years from 2009 to 2015, nearly 500 U.S. banks failed
outright, while more than 1,300 merged, reflecting the most severe financial crisis
since the 1930s.
We have emphasized repeatedly that financial and economic development go hand in
hand. An economy that lacks the financial institutions to effectively channel resources
298 l Chapter 12 Depository Institutions: Banks and Bank Management
from savers to investors is much less likely to thrive. This statement applies regardless
of whether a country is rich or poor. The United States and Japan provide a striking
example. By virtually any standard, both countries are well off. Yet during the 1990s,
U.S. banks made substantial profits, while Japanese banks suffered prodigious losses.
At the same time, Japan’s economy grew at a rate of just over 1 percent, while the U.S.
economy grew at a rate well over 3 percent. The financial problems of Japanese banks
played an important role in Japan’s poor economic performance. Banks are important;
when they are poorly managed, we all suffer. Similarly, the damage to U.S. banks in
the crisis of 2007–2009 helped make the U.S. recovery that began in 2009 the weakest
since the Great Depression.
In this chapter, we will examine the business of banking. We will see where depository
institutions get their funds and what they do with them. That is, we will study
the sources of banks’ liabilities and learn how they manage their assets. And because
banking is a risky business, we will examine the sources of risk that bankers face, as
well as how those risks can be managed.
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).
Table 12.1 shows a consolidated balance sheet for all the commercial banks in the
United States in December 2015. It reports the sum of all the items on all the balance
sheets of the 5,380 commercial banks that existed in the United States at the time.
The government collects these statistics in the course of supervising and regulating
the financial system, to ensure bank safety and soundness. The numbers in the table are
also related to the measures of money discussed in Chapter 2. Recall that the monetary
aggregate M2 includes deposits, which are liabilities of the banking system.
Assets: Uses of Funds
Let’s start with the asset side of the balance sheet—what banks do with the funds
they raise. Table 12.1 shows that assets are divided into four broad categories: cash,
securities, loans, and all other assets. Roughly 20 percent of assets, or $3.1 trillion, is
held in the form of securities; 56 percent ($8.7 trillion) in the form of loans; and the
remaining 24 percent, in the form of cash and “other assets.” The last category includes
The Balance Sheet of Commercial Banks Chapter 12 l 299
mostly buildings and equipment, as well as collateral repossessed from borrowers who
defaulted. In looking at consolidated figures like the ones in Table 12.1, we can get
some sense of their scale by comparing them to nominal GDP. In the fourth quarter of
2015, U.S. nominal GDP was roughly $18.2 trillion, so total bank assets were equivalent
to nearly 85 percent of one year’s GDP.
Cash Items 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 ATM machines), 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
Balance Sheet of U.S. Commercial Banks, December 2015Table 12.1
Assets in billions of dollars (numbers with % sign are percentages of total assets)
Cash items
Securities*
U.S. government and agency
Other securities
Loans
Commercial and industrial
Real estate (including mortgage)
Consumer
Interbank
Other (including loss allowance)
Other Assets (including trade allowance)
Total Commercial Bank Assets
2,220
877
1,977
3,864
1,270
62
1,418
14.3%
5.6%
12.7%
24.9%
8.2%
0.4%
9.1%
2,548
3,097
8,591
1,296
15,532
16.4%
19.9%
55.3%
8.3%
Liabilities in billions of dollars (numbers with % sign are percentages of total liabilities)
Deposits
Large time deposits
Borrowings
From banks in the U.S.
From others
Other liabilities
Total Commercial Bank Liabilities
Bank Capital = Bank Assets – Bank Liabilities
1,669
105
1,779
12.1%
0.8%
12.9%
10,912
1,885
1,028
13,825
1,707
78.9%
13.6%
7.4%
11.0%
*Securities include mortgage-backed securities worth $1,677 billion, equivalent to 10.8% of assets.
SOURCE: Data are for the end of 2015, seasonally adjusted, from Board of Governors of the Federal Reserve System statistical release
H.8. “Assets and Liabilities of Commercial Banks in the United States,” available at www.federalreserve.gov/releases/h8/current.
300 l Chapter 12 Depository Institutions: Banks and Bank Management
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 2015, banks held more than 16 percent of their assets in cash (see
Table 12.1). Up to the financial crisis of 2007–2009, that share was much smaller (in
early 2007, it was about 3 percent; see Figure 12.1). 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.
Securities 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 14.3 percent of their assets, and other securities
(including state and local government bonds), which account for an additional 5.6 percent.1
TIME
1
While there is nothing to prevent banks from holding corporate bonds, regulatory rules make the practice
expensive. In Chapter 14, we will learn that banks are required to hold capital based on the composition of
their balance sheets. The amount of capital required to extend a loan to a corporation is the same as the amount
required to purchase a corporate bond. But because interest rates banks can charge on loans are generally higher
than interest rates on corporate bonds, there is no price incentive to purchase a bond.
U.S. Commercial Bank Assets, 1973–2016Figure 12.1
SOURCE: Monthly data, seasonally adjusted from “Assets and Liabilities of Commercial Banks in the United States,” Board of Governors of the Federal Reserve
System Statistical Release H.8. (FRED data codes: INVEST, REALLN, CONSUMER, BUSLOANS, CASACBM027SBOG, and TLAACBM027SBOG).
0%
PercentageofTotal
1973 1977 1981 1989 1993 2001 2005 2009
Securities Real Estate Consumer Loans C&I Loans Cash
19971985
5%
10%
15%
20%
25%
30%
35%
20172013
The Balance Sheet of Commercial Banks Chapter 12 l 301
Note that more than half of all the securities are mortgage-backed (10.8 percent 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.
Figure 12.1 shows the trends in the composition of bank assets over the past four
decades. Focusing on the line representing securities, we can see that the share of
securities in bank assets has varied around 20 percent throughout the period.
Loans 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. (We discussed this process in Chapter 3,
in connection with asset-backed securities.) Others, like small business loans, may be
very difficult to resell.
The primary difference among various kinds of depository institutions is in the
composition of their loan portfolios. Commercial banks make loans primarily to businesses;
savings and loans provide mortgages to individuals; credit unions specialize
in consumer loans. See the Tools of the Trade box on page 306 for a more detailed
description of the various types of depository institutions.
Figure 12.1 shows that, prior to the crisis of 2007–2009, commercial banks became
more and more involved in the real estate business. Their involvement grew for a number
of reasons. 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. (Commercial paper is described in Chapter 7.) Second, the
creation of mortgage-backed securities 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 mortgage-backed securities (MBS), which recently
accounted for more then half of securities held (see Table 12.1). 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 (see Lessons from the
Crisis: Information Asymmetry and Securitization in Chapter 11, page 284).
Liabilities: Sources of Funds
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 (see Chapter 11), 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 2015, checkable deposits totaled $1.87 trillion,
or roughly 17 percent of total deposits in the commercial banking system.
Checkable Deposits “Demand deposits,” which allow a customer to withdraw
funds without notice on a first-come, first-served basis, make up the largest component
302 l Chapter 12 Depository Institutions: Banks and Bank Management
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 17 percent at the end
of 2015. 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.
Nontransaction Deposits In December 2015, nontransaction deposits, including
savings and time deposits, accounted for more than half of all commercial bank
2
This is also related to a practice called deposit sweeping, in which banks take checking account balances and put
them into savings deposits, thereby reducing the level of reserves they are required to hold. Over recent decades,
deposit sweeping has lowered required reserves even as the monetary aggregates have risen markedly.
YOUR FINANCIAL WORLD
Choosing the Right Bank for You
Choosing the right bank takes some work. First, you should
decide exactly why you need a bank and whether a particular
bank will serve your needs conveniently and cheaply. Shop
around for the best deal. Make sure the bank will pay a competitive
interest rate on your deposit balance and you won’t
be paying for services you don’t use. You may want to make
sure the bank will give you immediate access to your deposits.
The ability to reach someone either in person or on the
phone during hours that are convenient for you is also important.
And be sure the bank has a reputation for courteous,
efficient service. Because service isn’t cheap, ask what it will
cost you. Will you have to pay a fee to see a teller in person?
Will you have to pay a fee to cash a check? If you have friends
with needs similar to yours, find out where they bank and ask
whether they’re happy with the cost and service.
The Internet has revolutionized banking. Traditional
“bricks and mortar” banks now provide many of their services
on the Internet. Using your smartphone or computer,
you can access your account, review and pay your bills,
or transfer funds. In fact, when you decide to open a bank
account, you may be tempted to give your business to an
Internet bank—one without any local branches. If you do, be
careful. Looking at your computer screen, you may not be
able to tell where the website you are viewing is physically
located. While many people think the irrelevance of physical
location is a real benefit of the Internet, in making financial
transactions, it presents a challenge. Unfortunately, U.S. laws
and regulations may not protect transactions with institutions
located outside the United States. Instead, the laws and regulations
of a foreign bank’s home country may apply. So if
you choose an Internet bank, make sure that its operations
are located in the United States. The easiest way to find out
is to verify that the bank is a member of the Federal Deposit
Insurance Corporation (FDIC). You can check by going to
http://research.fdic.gov/bankfind. If a bank is listed there, it
is a legitimate U.S. bank, and your deposits will be insured.
The Balance Sheet of Commercial Banks Chapter 12 l 303
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.
Borrowings Borrowing is the second most important source of bank funds.
Figure  12.2 shows that borrowing grew increasingly important over the past four
decades, until the financial crisis of 2007–2009 triggered greater bank caution. Today,
borrowings account for somewhat less than 15 percent 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.
U.S. Commercial Bank Liabilities, 1979–2016Figure 12.2
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Percentage
Deposits Borrowing
1981
1979
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2017
2015
2011
2013
2009
2007
SOURCE: Monthly data, seasonally adjusted from “Assets and Liabilities of Commercial Banks in the United States,” Board of Governors of the Federal Reserve
System Statistical Release H.8. (FRED data codes: DPSACBM027SBOG, BOWACBM027SBOG, and TLBACBM027SBOG).
304 l Chapter 12 Depository Institutions: Banks and Bank Management
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. Look back at the
balance sheet in Table 12.1; you will see interbank loans listed as an asset and borrowings
from banks in the United States listed as a liability.3
Besides borrowing from U.S. banks in
the federal funds market, commercial banks also borrow from foreign banks and from U.S.
government-sponsored enterprises that hold deposits at the Federal Reserve.
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. The details are shown in Figure 12.3.
Mechanics of an Overnight Repurchase AgreementFigure 12.3
Day One
Bank sells U.S. Treasury bill to pension fund in exchange for cash
U.S. Treasury bill to pension fund
Bank Pension fund
Cash to bank
Day Two
Bank repurchases U.S. Treasury bill from the pension fund
in exchange for cash plus interest
U.S. Treasury bill returned to bank
Bank Pension fund
Cash + interest paid to pension fund
3
An astute reader will notice that the amount of “Interbank loans” on the asset side of the balance sheet does not
match the amount for “Borrowings from Banks in the U.S.” on the liability side of the balance sheet. In fact, the
two amounts differ by more than $40 billion. If the data in the table cover the entire banking system, shouldn’t
loans to banks (assets) equal borrowings from banks (liabilities)? There are two reasons why the amounts do not
match. First, the data in the table are constructed from a survey that covers all large banks but only a minority
of small banks. Large banks tend to be borrowers, while small banks tend to be lenders. The way in which the
data are collected, then, distorts the comparison. Second, small banks may report their lending to large banks
as deposits rather than as interbank loans. For both these reasons, the entry on the liability side of Table 12.1 is
larger than the corresponding entry on the asset side.
The Balance Sheet of Commercial Banks Chapter 12 l 305
Bank Capital and Profitability
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.
Looking once again at the balance sheet in Table 12.1 (page 299), we can see that
in December of 2015, bank capital in the U.S. commercial banking system totaled
$1.7 trillion. That $1.7 trillion of capital was combined with $13.8 trillion worth
of liabilities to purchase $15.5 trillion in assets. So the ratio of debt to equity in the
U.S. banking system was about 8 to 1. That’s a substantial amount of leverage, but
it is nearly 25 percent below the average commercial bank debt-to-equity ratio that
prevailed prior to the financial crisis of 2007–2009. As we saw in Chapter 3, Lessons
from the Crisis: Leverage, the crisis compelled banks to reduce their leverage sharply.
(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 debt-to-equity
ratio for nonfinancial businesses in the United States, which is less than 1 to 1.
Household leverage is much lower, roughly 1
⁄3 to 1.4
Recall from Tools of the Trade
in Chapter 5 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 (see the Tools
of the Trade box in Chapter 5). So if a bank borrows $8 for each $1 in capital, its risk
and expected return increase a whopping 9 times! Banking, it seems, is a very risky
business. As we will see in Chapter 14, 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.
There are several basic measures of bank profitability. The first is called return on
assets (ROA). Return on assets equals a bank’s net profit after taxes divided by the
bank’s total assets:
ROA =
Net profit after taxes_________________
Total bank assets
(2)
4
You can arrive at these figures yourself by looking at the Financial Accounts of the United States, which is
computed by the Board of Governors of the Federal Reserve (see its website). The appropriate tables are L.100
for households and L.102 for nonfarm nonfinancial corporate business; both include assets, liabilities, and net
worth for their parts of the U.S. economy.
306 l Chapter 12 Depository Institutions: Banks and Bank Management
TOOLS OF THE TRADE
A Catalog of Depository Institutions
While the financial landscape is constantly shifting, it is safe
to assume that depository institutions will be with us for
some time. These are the financial intermediaries for whom
deposits are the primary source of funds. There are three
basic types of depository institution: commercial banks, savings
institutions, and credit unions.
Commercial Banks
A commercial bank is an institution that accepts deposits
and uses the proceeds to make consumer, commercial, and
real estate loans. Originally established to meet the needs
of businesses, many of these banks now serve individual
customers as well. Commercial banks tend to specialize as
community, regional and super-regional, or money center
banks. As a result of mergers during the crisis of 2007–
2009, more than one-third of U.S. commercial bank deposits
are in four institutions (ranked in order of deposits): Bank
of America, JPMorgan Chase, Wells Fargo, and Citigroup.
Community Banks
Community banks are small banks—those with assets of less
than $1 billion—that concentrate on serving consumers and
small businesses. These are the banks that take deposits
from people in the local area and lend them back to local
businesses and consumers. Of the roughly 6,200 banks and
savings institutions in the United States at the end of 2015,
more than 90 percent were community banks.
Regional and Super-Regional Banks
Regional and super-regional banks are larger than community
banks and much less local. Besides consumer and
residential loans, these banks also make commercial and
industrial loans. Regional banks obtain their funds through
borrowing as well as from deposits. These banks can be
very large. When the largest regional bank, Wachovia, faced
a bank run in 2008, it was taken over by Wells Fargo.
Money Center Banks
A few large banks—only five or six—do not rely primarily on
deposit financing. These banks rely instead on borrowing
for their funding. They stand at the center of the wholesale
money market, the market for short-term debt. Citigroup and
JPMorgan Chase are two examples. (Recall from Chapter 3
that money-market instruments are bonds with a maturity of
less than 12 months.)
Savings Institutions
Savings institutions are financial intermediaries that were
established to serve households and individuals. They provide
both mortgage and lending services and a place for
households to deposit their savings. There are two types of
savings institutions, S&Ls and savings banks.
Savings and Loan Institutions
Savings and loan institutions (S&Ls) were established in the
1800s to help factory workers become homeowners. They
accepted workers’ savings deposits and used the funds to
make loans to homebuyers, most of whom were not served
by traditional banks. These institutions traditionally specialized
in taking short-term deposits and turning them into residential
mortgages. The S&Ls that still exist today engage in a
much broader range of financial activities.
Savings Banks
Most savings banks are mutually owned. That is, the depositors
are also the legal owners. These institutions specialize in
residential mortgages that are funded by deposits. They are
permitted to exist only in certain states. When the largest
savings bank, Washington Mutual, failed during the crisis of
2007–2009, JPMorgan Chase acquired its deposits.
Credit Unions
Credit unions are nonprofit depository institutions that are
owned by people with a common bond—members of police
associations, union members, and university students and
employees. Credit unions specialize in making small consumer
loans. They originated in the 19th century to meet the
needs of people who could not borrow from traditional lenders.
Before credit unions existed, many ordinary people had
nowhere to turn when they faced unexpected home repairs
or medical emergencies.
Not all these depository institutions are likely to survive
the financial innovations and economic upheaval of the coming
decades. Commercial banks will likely remain with us, but
savings institutions have already declined in importance and
are at risk of disappearing altogether due to changes in the
mortgage business. Whether credit unions remain viable will
depend on their continuing ability to exploit their advantage in
verifying members’ creditworthiness.
The Balance Sheet of Commercial Banks Chapter 12 l 307
ROA is an important measure of how efficiently a particular bank uses its assets. By
looking at the different units’ ROAs, for example, the manager of a large bank can also
compare the performance of the bank’s various lines of business. But for the bank’s
owners, return on assets is less important than the return on their own investment,
which is leveraged at an average ratio of 9 to 1. (The leverage ratio equals total assets
divided by bank capital. It also equals the debt-to-equity ratio plus 1.) The bank’s
return to its owners is measured by the return on equity (ROE), which equals the
bank’s net profit after taxes divided by the bank’s capital:
ROE =
Net profit after taxes_________________
Bank capital
(3)
Not surprisingly, ROA and ROE are related to leverage. One measure of leverage
is the ratio of bank assets to bank capital. Multiplying ROA by this ratio yields ROE:
ROA × Bank assets___________
Bank capital
=
Net profit after taxes_________________
Total bank assets
× Bank assets___________
Bank capital
(4)
=
Net profit after taxes_________________
Bank capital
= ROE
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 pre-crisis 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.5
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.
Well-run banks have high net interest income and a high net interest margin. And
because we would expect most of a bank’s loans to be repaid, net interest margin tells
us not just current profitability but future profitability as well; it is a forward-looking
measure. If a bank’s net interest margin is currently improving, its profitability is likely
to improve in the future.
5
See John P. Hughes and Loretta Mester, “Who Said Large Banks Don’t Experience Scale Economies? Evidence
from a Risk-Return-Driven Cost Function,” Journal of Financial Intermediation, Volume 22, Issue 4, October
2013, pages 559–585.
308 l Chapter 12 Depository Institutions: Banks and Bank Management
Off-Balance-Sheet Activities
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 ChineseINFORMATION
APPLYING THE CONCEPT
SHADOW BANKING IN CHINA
By almost any measure, the residents of China save more
than virtually any other population in the world. Yet, until
recently, they have had few attractive avenues for investing.
Until 2015, for example, regulation capped bank deposit
rates at a level far below the growth rate of the economy. This
was part of a strategy whereby the government—through the
large state-controlled banks—funneled an outsized proportion
of national savings to favored borrowers, typically stateowned
enterprises (SOEs), at low interest rates. This is an
example of financial repression.
Enter shadow banking. In 2008, as the global economy
tanked, China sought to boost domestic demand by relaxing
the supply of credit. To fund the credit expansion, regulators
allowed banks and others to offer new products that looked
a lot like short-term deposits but with much higher interest
rates—often in excess of 10 percent. Hungry household
investors flocked to these products.
So, viewed in the most favorable light, the rise of
shadow banking in China constituted backdoor financial
liberalization. However, the rapid expansion of shadow
banking occurred in a financial system plagued by poor
incentives. Neither lenders (the banks and other intermediaries)
nor borrowers (especially SOEs and local government
financing vehicles—LGFVs) had much of an interest
in controlling risk taking. This, plus the lack of clarity about
who bears the risk of failure, fueled worries about financial
instability in China.
As a result of rapid credit growth, the ratio of overall credit
to GDP has soared since 2008 to more than 250 percent,
and nonfinancial corporations in China became the most
indebted among those in countries for which we have accurate
data. Furthermore, a significant portion of the credit in
China flowed through off-balance-sheet finance to LGFV real
estate projects that had uncertain prospects for repayment.
Experience teaches us that credit booms like this one are the
fuel for financial crises.
Fortunately, the Chinese government has considerable
wherewithal to steady the financial system even as many
loans go bad. But over time, government bailouts undermine
the discipline needed to make the financial system efficient.
Without the force of market discipline—including the trauma
of creditors bearing the losses from borrower failures—there
is little incentive to limit or even monitor risk taking.
The challenge for China’s authorities is to keep the benefits
of shadow banking while containing the risks. The recent
global crisis shows that this is difficult anywhere. For China,
it may be especially so. Some of the country’s most stunning
successes—including its rapid infrastructure development—
reflect the government’s virtually unrestrained use of authority. In
contrast, building a large and efficient financial system requires
curbing that authority so that—consistent with Core Principle
4—markets determine prices and allocate resources. It remains
to be seen whether the Chinese government can exhibit the
restraint needed to reap the benefits markets have to offer.
The Balance Sheet of Commercial Banks Chapter 12 l 309
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. SOURCE: 1985 © J.B. Handelsman/The New Yorker Collection/www.cartoonbank.com.
“What I’d like, basically, is a temporary line of credit
just to tide me over the rest of my life.”
YOUR FINANCIAL WORLD
The Cost of Payday Loans
If you drive through the streets of a U.S. city, you will eventually
pass a store with a sign saying “Checks Cashed.” Or, if you
start looking for a loan on the Internet, you will quickly find a
slew of lenders who advertise things like “Bad Credit Okay.”
These financial intermediaries lend to people who cannot
borrow from mainstream financial institutions such as banks.
The most common type of loan these stores and websites
offer is a payday loan. To get one, you need provide
only a very limited amount of information to identify yourself.
If you are doing this online, you will receive a deposit into
your bank account within a day or two and must agree to let
the lender directly debit your account when the loan is due,
usually within two weeks. If you make the transaction in a
store, you walk out with the cash.
The catch is a huge fee, typically equal to 15 percent of
the loan’s principal. So if you borrow $500, you will have
to repay a minimum of $575. In many cases, lenders are
required to disclose the implied annual interest rate on
these loans. It can exceed 2,000 percent, which should
give all but the most desperate borrowers pause.
But the main problem with these loans is that they trap
some borrowers in a vicious cycle of new fees for repeated
loan renewals. A study by the Consumer Financial Protection
Bureau (CFPB) reports that more than 80 percent of payday
borrowers take out another loan within two weeks.* And
15 percent of borrowers will roll over the original debt in
a series of 10 loans or more. For a $500 loan, 10 renewals
means the borrower will pay $825 in fees over a 22-week
period and still owe the original $500!
To the extent that payday loans allow people to obtain
short-term loans from legitimate financial intermediaries, they
are a good thing. You will find testimonials on websites from
people who were clearly helped. But when payday loans lead
to a cycle of costly renewals, they can do substantial harm.
In response, the federal government is moving to protect
borrowers from certain lending practices. The Military Lending
Act caps lending rates and rollovers on loans to U.S. service
families. And, in June 2016, the CFPB proposed a set of rules
aimed at ending payday debt traps. New regulations would
require lenders to verify a borrower’s income and borrowing
history to ensure that the new loan can be repaid. The rules
also would limit renewals in the absence of a material improvement
in the borrower’s financial conditions. For further information,
visit the CFPB website (www.consumerfinance.gov).
*Consumer Financial Protection Bureau Office of Research,
“CFPB Data Point: Payday Lending,” March 2014.
310 l Chapter 12 Depository Institutions: Banks and Bank Management
Because off-balance-sheet activities create risk for financial institutions, they have
come under increasing scrutiny in recent years. Recall the case of Long-Term Capital
Management (LTCM), which we discussed in Chapter 9. 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 (see Chapter 3, Lessons from the Crisis:
Shadow Banks). 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.
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.
Liquidity Risk
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
September 2008—and to the failures of numerous bank and nonbank intermediaries.
RISK