Understand the Bank's Balance Sheet
Assets vs liabilities
You need to understand that money in the economy is highly influenced by commercial banks. When commercial banks make loans, they are essentially creating money – putting money into the customer’s account ready for spending. This increases the money supply.
The customer who borrows money from a bank, is called a debtor. They need to repay the loan, but they also have to pay for the cost of borrowing the money. This is known as the interest.
When a bank gives out a loan, it becomes an asset to the bank. It is a liability for the customer.
The bank collects money from the customer. (Asset)
The customer has to pay the bank back. (Liability for the customer)
You can think of an asset as something that makes you money.
A liability loses you money (you have to pay it back).
What is a deposit from the bank’s perspective? Is it an asset or is it a liability?
The correct answer, is that the deposit from savers is a liability. The bank must pay this back. It does not belong to the bank. The bank is borrowing it from the customer.
Banks do not just borrow from customers, they can also borrow and lend to other banks. This is called inter-bank lending. There is a specific market for this called the inter-bank lending market. These loans between banks are very short-term, often overnight up to about 1 week.
Why do banks lend/borrow in the first place from one another?
Because sometimes a bank will have too much liquidity and it will want to make some more profit.
Other banks might not have enough liquidity. That creates the inter-bank lending market…because banks have needs and wants and other banks have the means to satisfy them.
Bank A needs some liquid cash today.
Bank B has plenty of liquid cash today.
Bank B will lend to Bank A at the inter-bank lending rate (overnight rate).
This will generate Bank B some interest, which will mean more profit for its shareholders.
This will mean Bank A is able to meet the needs of its depositors and other needs for liquid money of the business.
The Bank Balance Sheet
A bank is a business – it too, has a balance sheet which sums up its assets and liabilities.
List of Assets (in order of liquidity, liquid to illiquid)
1. Cash
2. Balances at the central bank
3. Money at call and short notice e.g. inter-bank lending
4. Commercial and Treasury bills
5. Investments e.g. bonds, shares
6. Advances e.g. loans and mortgages
7. Fixed assets e.g. land or buildings
Liabilities
1. Deposits from savers
2. Short-term borrowing e.g. inter-bank borrowing
3. Long-term borrowing e.g. the bank issues bonds/securities
4. Capital (see a + b just below)
a) Reserves (retained profits)
b) Share capital
[Share capital + reserves = The bank’s capital]
A rule of the balance sheet is that it must balance!
Assets must equal liabilities.
If the value of the bank’s assets falls for some reason (perhaps somebody defaulted on a loan), then this would also be deducted from the bank’s capital on the liability side (because it will make less profit). As you minus the same amount from assets and liabilities, then the balance sheet is still in balance.
However, if the assets of a bank falls by too large amount it could be a problem. If the fall in their assets is greater than the amount of capital they have, then the bank can become insolvent.
In this case, the value of assets would be lower than the value of liabilities. The bank would have to shut down and it would no longer be deemed creditworthy.
Therefore, in order to avoid insolvency, the bank needs to ensure that the loans it makes are balanced between their riskiness and profitability.
Unsecured loans are riskier and more profitable. However, lend too many of these and the bank could lose a lot of its assets if people fail to pay these loans back.
Secured loans are less risky and less profitable. However, if people fail to pay for their loans the bank’s assets are still secure because the bank can seize the borrower’s assets to pay for the loan e.g. repossessing their house. The loan is backed up by the borrower’s belongings essentially. This acts like an insurance policy to protect the bank from loss.
In summary, we have learned:
Inter-bank lending
The Balance Sheet
Profitability vs Riskiness
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