Liabilities

BANKS

ASSETS AND LIABILITIES OF

UNIT 5.

DISCUSSION 1. How do banks make their money?

2. What is the current situation in the sphere of banking in Ukraine?

3. What do you think about the problem of bankruptcy of banks in Ukraine?

reading THE BANK'S ASSETS AND LIABILITIES

To understand how a bank operates, first we need to examine its balance sheet, a list of the bank's assets and liabilities. As the name implies, this list balances, that is, it has the characteristic that total assets = total liabilities + capital

Furthermore, a bank's balance sheet lists sources of bank funds (liabili­ties) and uses to which they are put (assets). Banks obtain funds by bor­rowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by charging an interest rate on their holdings of securities and loans that is higher than the expenses on their liabilities.

The assets (uses of funds) of commercial banks include reserves, cash in process of collection, deposits at other banks, securities (government, state and local government and other securities), loans (commercial and indus­trial, real estate, consumer, interbank), and other assets (for example, physical capital).

The liabilities (sources of funds) of commercial banks include checkable deposits, non-transaction deposits (savings deposits, small-denomination -less than $100,000 - time deposits, large-denomination time deposits), borrowings, and bank capital.

PART III. BANKING

A bank acquires funds by issuing (selling) liabilities, which are conse­quently also referred to as sources of funds. The funds obtained from issu­ing liabilities are used to purchase income-earning assets.

Checkable Deposits. These are bank accounts that allow the owner of the account to write cheques to third parties. Checkable deposits include all accounts on which cheques can be drawn: non-interest-bearing check­ing accounts (demand deposits), interest-bearing NOW (negotiable order of withdrawal) accounts, and money market deposit accounts (MMDAs). Introduced in 1982, MMDAs have similar features to market money mutual bonds and are included into checkable deposits category. However, MMDAs differ from checkable deposits in that they are not subject to reserve requirements like checkable deposits. Once checkable deposits were the most important source of bank funds, but with the appearance of the new, more attractive financial instruments (such as money market mutual funds), the share of checkable deposits in total bank liabilities has shrunk over time.

Checkable deposits and money market deposit accounts are payable on demand, that is, if a depositor shows up at the bank and requests payment by making a withdrawal, the bank must pay the depositor immediately.

A checkable deposit is an asset for the depositor because it is part of his or her wealth. Conversely, because the depositor can withdraw funds from his or her account that the bank is obligated to pay, checkable deposits are a liability for the bank. They are usually the lowest-cost source of bank funds because depositors are willing to forgo some interest in order to have access to a liquid asset that can be used to make purchases. The bank's costs of maintaining checkable deposits include interest payments and the costs incurred in servicing these accounts - processing and storing canceled cheques, preparing and sending out monthly statements, provid­ing efficient tellers (human or otherwise), maintaining an impressive build­ing and conveniently located branches, and advertising and marketing to entice customers to deposit their funds with a given bank. In recent years, interest paid on deposits (checkable and time) have account for around 40% of total bank operating expenses, while the costs involved in servicing accounts (employee salaries, building rent and so on) have been approxi­mately 45% of operating expenses.

Non-transaction Deposits. Non-transaction deposits are the primary source of bank funds. Owners cannot write cheques on non-transaction deposits, but their interest rates are usually higher than those on checkable deposits. There are two basic types of non-transaction deposits: savings accounts and time deposits (also called certificates of deposits, CDs).

Savings accounts were once the most common type of non-transaction deposit. In these accounts, to which funds can be added or withdrawn at any time, transactions and interest payments are recorded in a monthly statement or in small book (the passbook) held by the owner of the account. Technically, the form of deposit is not payable on demand (the bank can wait up to 30 days to pay), however, because of competition for deposits, banks allow depositors to make withdrawals from their savings accounts without delay.

UNIT 5. ASSETS AND LIABILITIES OF BANKS 187

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Time deposits have a fixed maturity length ranging from several months to over five years and have substantial penalties for early withdrawal (the forfeiture of several months' interest). Small-denomination time deposits (deposits of less than $100,000) are less liquid for the depositors than pass­book savings, earn higher interest rates and are a more costly source of funds for the banks.

Large-denomination time deposits are available in denomination of $100,000 or over and are typically bought by corporations or other banks. Large-denomination CDs are negotiable, like bonds, they can be resold in a secondary market before they mature. For this reason, negotiable CDs are held by corporations, money market mutual funds and other financial institutions as alternative assets to Treasury bills and other short-term bonds. Since 1961, when they first appeared, negotiable CDs have become an important source of bank funds.

Borrowings. Banks obtain funds by borrowing from the Federal Reserve System, other banks and corporations. Borrowings from the Fed are called discount loans. Banks also borrow reserves overnight in the federal (Fed) funds from other US banks and financial institutions. Other sources of borrowed funds are loans made to banks by their parent compa­nies (bank holding companies), loan arrangements with corporations (such as a repurchase agreements), and borrowings of Eurodollars (deposits denominated in US dollars residing in foreign banks or foreign branches of US banks). Borrowings have become a more important source of bank funds over time.

Bank capital. The final category on the liabilities side of the balance sheet is bank capital, the bank's net worth, which equals the difference between total assets and liabilities. The funds are raised by selling new equity (stock) or from retained earnings. Bank capital is a cushion against a drop in the value of its assets, which could force the bank into insolvency (when the value of bank assets falls below its liabilities, meaning that the bank is bankrupt). One important component of bank capital is loan loss reserves.

Assets

A bank uses the funds that it has acquired by issuing liabilities to pur­chase income-earning assets. Bank assets are thus naturally referred to as uses of funds, and the interest payments earned on them are what enable banks to make profits.

Reserves. All banks hold some of the funds they acquire as deposits in an account at the Fed. Reserves are these deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults overnight).

Although reserves currently do not pay any interest, banks hold them for two reasons. First, some reserves, called required reserves, are held because, by law, the Fed requires that for every dollar of checkable depo­sits at a bank, a certain fraction (10 cents, for example) must be kept as reserves. This fraction (10% in the example) is called the required reserve ratio. Second, additional reserves, called excess reserves, are held because they are the most liquid of all bank assets and can be used by a bank to

PART III. BANKING

meet its obligations when funds are withdrawn, either directly by a deposi­tor or indirectly when a cheque is written on an account.

Cash in Process of Collection. Suppose that a cheque written on an account at another bank is deposited in your bank and the funds for this cheque have not yet been received (collected) from the other bank. The cheque is classified as a cash in process of collection and it is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days.

Deposits at Other Banks. Many small banks hold deposits in larger banks in exchange for a variety of services, including cheque collection, foreign exchange transactions, and help with securities purchases.

Securities. A bank's holdings of securities are an important income-earning asset. These securities can be classified into three categories: US government securities, state and local government securities and other securities. US government securities are the most liquid because they can be easily traded and converted into cash with low transactions costs. Because of their high liquidity, short-term US government securities are called secondary reserves.

State and local government securities are desirable for banks to hold not only because of their tax advantages but also because state and local governments are more likely to do business with banks that hold their securities.

State and local securities are less marketable (hence less liquid) and are also riskier than US government securities, primarily because of default risk. There is some possibility that the issuer of the securities may not be able to make its interest payments or pay back the face value of the securi­ties when they mature. Because these securities are less liquid and riskier than US government ones, their expected returns (after taxes) are the highest.

Loans. Banks make their profits primarily by issuing loans. A loan is a liability for the individual or corporation receiving it but an asset for a bank because it provides income to the bank. Loans are typically less liquid than other assets because they cannot be turned into cash until the loan matures. If the bank makes a one-year loan for example, it cannot get its funds back until the loan comes due in one year. Loans also have a higher probability of default than other assets. Because of the lack of liquidity and higher default risk, the bank earns its highest return on loans.

The largest categories of loans for commercial banks are commercial and industrial loans made to business and real estate loans. Commercial banks also make consumer loans and lend to each other. The bulk of these interbank loans are overnight loans lent in the federal funds market. The major difference in the balance sheets of the various depository institu­tions is primarily in the type of loan in which they specialise. Savings and loans and mutual savings banks, for example, specialise in residential mortgages, while credit unions tend to make consumer loans.

Other Assets. The physical capital (bank buildings, computers and other equipment) owned by the banks is included in this category.

UNIT 5. ASSETS AND LIABILITIES OF BANKS

VOCABULARY balance sheet -баланс

NOTES assets - активи

liabilities - зобов'язання (пасиви) real estate - нерухомість checkable deposit - чековий депозит bank capital - банківський капітал consequently - у результаті, отже demand deposit - безстроковий вклад, депозит до запитання money market deposit account - депозит­ний рахунок грошового ринку (СІЛА) money market mutual fund -інвестиційний фонд відкритого типу, що вкладає кошти у короткотермінові зобов'язання conversely -навпаки to forgo - відмовлятися, утримуватися від чогось teller - касир

operating expenses - поточні/операційні витрати

certificate of deposit (CD) - депозитний сертифікат

passbook - ощадна книжка; банківська розрахункова книжка costs - витрати, видатки to entice - спокушати

delay - затримка

forfeiture - втрата, конфіскація

negotiable - оборотний; такий, що

можна передавати

bond - облігація

secondary market - вторинний ринок

discount loan - позика із заздалегідь

виплаченими процентами

parent company - компанія-засновник,

материнська компанія

to reside - перебувати, міститися

insolvency - неплатоспроможність

required reserve ratio - норма резервного

покриття, що вимагається

excess reserves - надлишкові резерви

claim - претензія

marketable - ліквідний, придатний для

продажу

default risk - кредитний ризик

face/par/nominal value - номінальна

вартість

due - належний до виплати

federal funds market - ринок

федеральних фондів (США)

residential mortgage loan - кредит під

заставу житлового будинку

Дата добавления: 2014-12-23