Banking and the Management of

Financial Institutions
 Commercial Banks play an important role in
channeling funds from those with excess of funds to
those with shortage of funds (productive investment
opportunities).
Need To Know
Commercial banks are financial intermediaries.
- Why banks are important?
- How banking is conducted to earn the highest profits?
- How and why banks make loans?
- How banks acquire and manage funds
(assets\liabilities)?
1- The Bank Balance Sheet
- Total Assets = Total Liabilities + Capital
- The banks balance sheet lists:
Liabilities: sources of bank funds, and Assets: uses
with which funds are put.
- Banks obtain funds by borrowing and by issuing other
liabilities (deposits).
- Banks use funds to acquire assets:
(securities, loans, ...)
- Banks make profits by: charging an interest rate on
their holdings (securities, loans, ) that is higher than
the costs of their liabilities (deposits,).
Balance Sheet of a Commercial Bank

Assets (A) Liabilities (L)

(Uses of Funds) Sources of Funds)
- Reserves (including cash items) - Deposits (D):
RR + ER Checkable Deposits
- Securities Non-transaction D
- Loans Saving D
- Other Assets (physical assets) Small denomination time D
Large denomination time D
- Borrowings
- Bank Capital

Total = X Total = X
 - Liabilities: Sources of funds. These funds are
obtained by issuing (selling) liabilities:
A. Checkable deposits:
all bank accounts that allow the owner of the account
to write checks to third party.
Checkable deposits are bank liabilities because the
owner of the deposit can withdraw from the account
funds that the bank is obligated to pay.
 The primary source of bank funds, Owner cannot
write checks, but earn higher interest than those on
checkable deposits. This includes: savings accounts
and times deposits (small and large (CDs)).
B. Nontransaction deposits:
C. Borrowings: from the central bank (discount loans)
and other commercial banks (overnight).
D. Bank Capital: the banks net worth: the difference
between total assets and liabilities.
Funds are raised by: selling new equity (stock) or
retained earnings.
Used against a drop in banks assets.
 Assets: uses of funds, the bank acquired these funds by
issuing liabilities in order to purchase income earning
assets.
A. Reserves:
Some of the funds that the bank acquire that are deposited
at the central bank + Currency held by the bank (vault
cash).
 Reserves do not pay interest but the bank do hold
them because:
1- Reserve Requirements (required reserve ratio)
2- Excess Reserve
Both can be used to meet obligations when funds are
withdrawn.

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 B. Cash items in process of collection

C. Deposits at other banks

D. Securities: an important income-earning asset:

(securities: debt instruments for commercial banks.

E. Loans: a liability for second party (individual or firm)

receiving it but considered a banks asset.

F. Other assets: Physical capital.

General Principles of Bank Management
1. Liquidity management

2. Asset management
Managing credit risk
Managing interest-rate risk

3. Liability management

4. Managing capital adequacy

Asset Management
Asset Management: the attempt to earn the highest
possible return on assets while minimizing the risk.
1. Get borrowers with low default risk, paying high
interest rates
2. Buy securities with high return, low risk

3. Diversify

4. Manage liquidity
Liability Management

Liability Management: managing the

source of funds, from deposits, to CDs,
to other debt.
1. Important since 1960s

2. No longer primarily depend on deposits

3. When see loan opportunities, borrow or issue CDs

to acquire funds

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Capital Adequacy Management

1. Bank capital is a cushion that prevents

bank failure
2. Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets
ROE = Net Profits/Equity Capital
EM = Assets/Equity Capital
ROE = ROA EM
Capital , EM , ROE
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Measuring Bank Performance

Much like any business, measuring bank performance requires a

look at the income statement. For banks, this is separated
into
three parts:
Operating Income
Operating Expenses
Net Operating Income

Note how this is different from, say, a manufacturing firms

income statement.

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