UNIT 1: COMMERCIAL BANKING

Content
1.0 Aims and Objectives
1.1 Introduction
1.2 The Commercial Bank Balance Sheet
1.3 Commercial Bank Liabilities
1.4 Transaction Deposits
1.5 Non Deposit Borrowing
1.6 Other Liabilities
1.7 Commercial Bank Assets
1.8 Commercial Capital Accounts
1.9 Commercial Bank Management
1.10 Liquidity Management
1.11 Summary
1.12 Answers to Check Your Progress Questions
1.13 Model Examination Questions

1.0 AIMS AND OBJECTIVES

 To have a look at the business of banking.

 To examine the commercial bank balance sheet and the sources and uses of bank
funds (liabilities and assets).
 To study the principles and constraints governing the management of bank assets
and liabilities.
 To understand the concepts of bank liquidity and capital adequacy,
 To appreciate the reasons why banks sometimes become insolvent.
 To concentrate primarily on savings institutions and credit unions in general and
commercial banks in particular.

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1.1 INTRODUCTION

Depository institutions, or "banks play a key role in channeling funds from savers to
borrowers and investors. Banks loans to students, homebuyers, consumers, and
businesses and provide us with services such as checking and savings accounts. Among
depository institutions, commercial banks are clearly the dominant players. They are also
the oldest and most diversified of all financial intermediaries. In December 1996,
commercial banks had some $4.7 trillion in total assets more than 75 percent of the total
assets of all depository institutions (commercial banks, savings and loan associations,
mutual savings banks, and credit unions) combined.

However, our interest in banks stems not only from their dominant role among financial
intermediaries but also from the special role they play in the money supply process. A
substantial portion of the claims banks issue (checking accounts) circulates as money. In
fact, the dominant portion of our transactions measure of the money supply (M1) consists
of commercial bank checking accounts. Through the process of lending and investing in
securities, commercial banks create new money. Banking activity is the major conduit
through which Federal Reserve monetary policy influences the nation's credit conditions
and money supply. For all these reasons, commercial banking merits special attention.

Because of the key role banks play in the economy, a financially healthy banking sector
is important to the nation's economic well-being. In the past 15 to 20 years banks have
been challenged by financial innovation, deregulation and globalization in the process,
their profitability has fluctuated significantly. Banks went through hard times in the late
1980s and early 1990s, out since 1992 their financial condition has strengthened
materially.

In this chapter we will look at the business of banking. We will examine the commercial
bank balance sheet and the sources and uses of bank funds (liabilities and assets). We will
study the principles and constraints governing the management of bank assets and
liabilities. We will look at the concepts of bank liquidity and capital adequacy, and we
will discuss the reasons banks sometimes become insolvent. Though much of the analysis

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of this chapter applies also to savings institutions and credit unions. We will concentrate
primarily on commercial banks.

1.2 THE COMMERCIAL BANK BALANCE SHEET

Banks are in business to earn a profit. They do so by borrowing funds (issuing debt) at
relatively low interest rates and lending or investing the funds at higher interest rates. The
"spread" between the rate banks pay for funds and the rate they earn is the major
determinant of bank profits, although in recent years service fees have increased in
importance.

Perhaps the best way to learn about the business of banking is to examine a typical bank's
balance sheet. The balance sheet of any entity (business firm, individual, government) is
a statement of its assets, liabilities, and net worth at a given point in time. A bank's assets
are indications of what the bank owns, or claims the bank has on external (non bank)
entities: individuals, firms, governments. A bank's liabilities are indications of what the
bank owes, or claims on the bank that are held by external entities. A fundamental and
simple accounting identity is the following:

Assets - Liabilities = Net Worth

Assets = Liabilities + Net Worth

Net Worth is a residual term that is calculated by subtracting total liabilities from total
assets. In banking, net worth is known as capital accounts, or simply capital. Capital
accounts may be viewed as the value of the owners' residual claim on the bank's assets
that is, the owners' equity in the bank. This item is listed on the right hand side of the
balance sheet, below liabilities, so that the two sides of the balance sheet always balance.

Another way of viewing the balance sheet is as a statement of the sources of and uses for
bank funds. Banks obtain funds by issuing debt (liabilities) in the form of demand
deposits and savings and time deposits, by borrowing funds from other banks or the
public, and by obtaining equity funds from the owners (shareholders) of the bank through
the capital accounts. Banks use these funds to grant loans, invest in securities, purchase
equipment and facilities, and hold cash items such as currency and deposits in other

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banks. These are the banks' assets. Loans and securities are the banks' earning as sets.
The interest earned from loans and securities generates the bulk of commercial banks'
revenues. These revenues are used to cover the cost of bank operations and to provide a
profit for the banks' owners. Figure 9-1 illustrates the sources of and uses for commercial
bank funds.

Table 9-1 shows the collective balance sheet of all U.S. commercial banks in March
1996. Each item on the balance sheet is expressed as a percentage of total Asses. We will
examine bank liabilities-that is, the sources of bank funds-first, followed by bank as sets
and then by bank capital.

Deposits Non-deposit Capital

borrowing

Non-deposit
borrowing

Reserves Loans Securities Other

assets

Figure 9-1 sources of and uses for commercial Bank Funds. Commercial banks obtain
funds by issuing deposits, borrowing from no deposit sources, and purchase securities.

1.3 COMMERCIAL BANK LIABILITIES

Bank liabilities are the funds banks obtain and the debts they incur, primarily to make
loans and purchase securities. These bank liabilities include various types of deposits,
borrowings, and other liabilities. Your bank deposit, which you regard as an asset, is
regarded by your bank as a debt that it, a liability. You have a claim on the bank: it owes
you the amount in your account.

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Bank deposits may be divided into two categories, transactions deposits and non
transactions deposits. We will examine the various types of deposit in each category,
beginning with transactions deposits.

1.4 TRANSACTIONS DEPOSITS

Transactions deposits, also known as checkable deposits, are deposits against which
checks may be written. Transactions deposits are payable on demand; you can walk into
your bank and withdraw funds from your checking account at any time. You can also
order your bank to transfer funds to someone else simply by writing a check.
Transactions deposits are the lowest-cost source of bank funds. Included in this category
are demand deposits, which are non-interest bearing checking accounts. Other types of
checkable accounts do pay interest. Included are negotiable order of withdrawal (NOW)
accounts, automatic transfer service (ATS) accounts, and money market deposit (MMD)
accounts. While individuals and non profit organizations may hold both demand deposits
and other types of checkable deposits, regulations prohibit banks from issuing NOW,
ATS, or MMD accounts to business firms. That is, profit-oriented business firms are not
allowed to hold interest bearing checking accounts in banks.

From the 1930s to the early 1980s federal law generally prohibited depository intuitions
from paying interest on checking accounts. Beginning in the late 1960s and especially in
the 1970s, as money market yields increased sharply, that prohibition began to cause
problems for depository institutions. Banks witnessed the phenomenon of disinter
mediation the active withdrawal of funds from depository institutions by customers in
search of higher yields. In 1972, after 2 years of litigation, savings banks in
Massachusetts were authorized to call a check a "negotiable order of withdrawal".

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Table 9-1
Balance sheet of U.S. Commercial Banks, March 1996(as a percentage of total
assets)
Assets (Uses of Funds) Liabilities (Sources of Funds)
Cash assets: 5.4% Deposits: 64.7%
Vault cash 0.9 Transactions deposits 20.4
Deposits with Federal Reserve 0.6 No transaction deposits 44.3
Deposits with other banks and
Cash items in r9ocess of collection 3.9 Borrowings 16.4
Loans: 61.7
Real estate 26.0 Other liabilities 10.6
Business 17.0
Consumer 11.7 Capital accounts 8.3
All other 7.0

Securities: 23.9
U.S. government 18.4
State and local government and other 5.5

Other assets 9.0

Total assets 100.0% Total liabilities and capital 100.0%

Source:
Source: Federal Reserve Bulletin.

Because the accounts, on which such checks were written, called NOW accounts, were
not considered demand deposits, they were not subject to the regulation that prohibited
the payment of interest. Thus, a NOW account is essentially a savings account on which
checks may be written. Though lobbyists for banks won an early ruling prohibiting the
spread of NOW accounts beyond New England, in 1980 the Depository Institution

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Deregulation and Monetary Control Act (DIDMCA) authorized nation wide issuance of
NOW accounts.

At the same time that NOW accounts were legalized nationwide, a similar instrument, the
ATS account (automatic transfer service), was authorized. With an ATS account, the
customer maintains a minimal checking account balance and holds additional funds in an
interest-bearing savings account. As checks drawn on the checking account are presented
for clearance the bank's computer automatically transfers sufficient funds from the
individual's savings account to the checking account to permit checks to clear and
maintain the minimum checking account balance. Like the NOW account, the ATS
account is essentially an interest bearing checking account.

Money market deposit (MMD) accounts are interest-bearing transactions deposits that
were authorized in 1982 to permit banks to compete with money market mutual funds.
MMD accounts offer only limited check-writing privileges: the yield payable fluctuates
with market yields. From the public's point of view. MMD accounts have an advantage
over MMMF shares in as much as the FDIC for up to $100,000 per account insures them.

Because MMD accounts are less likely to be withdrawn, and because they are not subject
to reserve requirements (a concept to be introduced shortly), banks can offer a higher
interest rate on MMD accounts than on NOW and ATS accounts. And though demand
deposits. NOW accounts, and ATS accounts are included in the Federal Reserve's narrow
measure of money (MD, MMD) accounts are not (they are included in M2). Despite their
check writing features, the Fed deems then more as a savings account than as a vehicle
for financing everyday expenditures.

Non-Transactions Deposits

Non-transactions deposits are interest-bearing deposits on which checks cannot be

written. Included within this category are passbook savings accounts, small consumer-
type time deposits or certificates of deposit (CDs), and large negotiable CDs issued in
minimum denominations of $100,000. Non-transactions deposits are currently the
primary source of bank funds, accounting for more than twice as many funds as
transactions deposits.

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For generations, passbook savings accounts have been popular with middle-class
Americans. They are symbolized by a little blue or green book (the passbook) in which
transaction and accrued interests are recorded. Passbook savings accounts are a highly
liquid vehicle for saving. Available in any denomination, they have no specific maturity
date; funds may be added to the account at any time. In practice, savings may be with
drawn on demand, although technically a bank may require 30 days advance notice. Once
a major source of bank funds, this type of deposit has declined in popularity chiefly
because of financial innovations that have made attractive new instruments available to
the public.

The deposits are issued in specific maturities, such as 3 months, 6 months, 1 year and so
forth. Fairly stiff penalties (in the form of loss of accrued interest) are levied for with
drawl prior to the maturity date. Because these instruments are less liquid and less likely
to be withdrawn than passbook savings accounts and MMD accounts, banks pay a higher
interest rate on them. They are therefore a more costly source of funds than passbook
savings accounts and money market deposit accounts. The longer the maturity of a CD,
the higher the interest rate paid by the bank. Over the years, CDs have become an
increasingly important source of bank funds.

Large negotiable CDs are issued in minimum denominations of $100,000 and are
typically purchased by corporations and money market mutual funds as an alternative to
short term government securities. Issued in specific maturities, they provide a reliable
source of funds for the large well-known banks that issue them. While negotiable CDs
are not redeemable prior to maturity by the bank, they may be traded in an active
secondary market and are therefore highly liquid. The volume of negotiable CDs
outstanding fluctuates with economic conditions. When credit demands escalate during
an economic expansion and the Federal Reserve moves to restrain bank lending, the
volume of negotiable CDs tends to escalate. From 1989-1992, as the U.S. economy
softened and credit demand declined the volume of negotiable CDs outstanding declined
by more than 25 percent. As the economy strengthened in 1994 and 1995, the volume of
negotiable CDs increased 25 percent.

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1.5 NON DEPOSIT BORROWING

In addition to borrowing from depositors, commercial banks borrow funds from the
Federal Reserve System from other banks and from corporations. Loans made by the Fed
to commercial banks are known as discount loans: the rate charged is called the discount
rate. Such loans are typically made for only 1 day and cannot be granted for the purpose
of extending additional loans to the public. Banks can also borrow funds overnight from
other banks (in the form of deposits at the Federal Reserve) in the federal funds market.
The interest rate payable is called the federal funds rate. Unlike borrowing from the
Federal Reserve banks may borrow continuously in the federal funds market and may use
the funds to grant loans or purchase securities. Federal funds are classified as
immediately available funds banks that borrow in this market obtain immediate credit in
their account at the Federal Reserve.

Banks also borrow from their parent companies (holding companies) through the latter's
issuing of commercial paper and from other corporations through repurchase agreements
(RPs). In an RP, a bank essentially borrows its corporate customers' checking account,
typically on an overnight basis, and pays a competitive interest rate for the privilege.
Finally, U.S banks borrow Eurodollars, dollar-denominated deposits held by foreign
banks or foreign branches of U.s. Banks. non deposit borrowing has emerged as an
important source of bank funds. The ration of borrowed funds to total bank assets has
increased from 2 percent in 1960 to more than 15 percent today.

1.6 OTHER LIABILITIES

Among the other liabilities banks carry are notes and bonds issued by the banks, bills
payable, and certain other items. This liability category is relatively small.

1.7 COMMERCIAL BANK ASSETS

Commercial banks use their funds primarily to purchase income earning assets. Bank
assets are divided into four categories: cash assets, loans, securities, and other assets.

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Note that more than 85 percent of total bank assets are income earning assets that is,
loans and securities.

The acquisition of earning assets by commercial banks is constrained by Federal Reserve

regulations that require banks to maintain a certain percentage of their deposit liabilities
in the non-interest earning form of legal reserves, or simply reserves. Reserves include
currency and coins in the bank plus the bank's deposit at the Federal Reserve. The
regulations that mandate the holding of reserves are referred to as reserve requirements,
or required reserve ratios. At the present time, reserve requirements apply only to demand
deposits, NOW accounts, and ATS accounts, although they have sometimes been levied
against savings and time deposits and certain other bank liabilities.

1.7.1 Cash Assets

Cash assets provide a bank with the funds to meet reserve requirements and the liquidity
to meet the withdrawal of deposits and accommodate new loan demand. Included in this
category are currency and coins (called "vault cash" because the funds are placed in the
bank vault after business hours): deposits with Federal Reserve banks; deposits with other
commercial banks; and cash items in the process of collection. Bank keep currency and
coins on hand to meet the public's demand for it, as well as to meet reserve requirements.
Besides helping to meet reserve requirements, commercial bank deposits with Federal
Reserve banks also facilitate the clearing of checks through the Federal Reserve's check
collection system.

Collectively commercial banks hold large demand deposit balances in other banks. Such
deposits derive from the system of correspondent banking, in which banks in small towns
deposit funds in larger bank's in return for a variety of services. These services include
the collection of checks, investment counsel, and assistance with transactions in securities
and foreign currencies. Essentially, the correspondent banking system extends the
expertise and economies of scale enjoyed by large banks to the nation's small banks. In
compensation for the services received, the smaller banks maintain deposit balances with
their larger correspondent banks.

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"Cash items in process of collection" refers to the total value of checks recently deposited
in banks that have not yet been credited to the banks' deposit accounts with the Federal
Reserve. This technical item corresponds to an item included in "other liabilities" (on the
liability side of the bank balance sheet) and is listed among bank assets to balance total
assets with total liabilities.

As a share of total bank assets, cash assets have declined from approximately 20 percent
to about 5 percent over the past 40 years, a phenomenon favorable to bank profitability.
Reductions in reserve requirements, together with a large reduction in the portion of total
bank liabilities made up by demand deposits and other checkable deposits subject to
reserve requirements, have caused the decline.

1.7.2 Loans
Loans are the largest source of income for banks: providing nearly 50 percent of total
bank revenue in 1995. Unlike securities, most bank loans involve a personal relationship
between banker and borrower. There are several types of bank loans, including, in order
of current magnitude, real estate loans (residential and non residential mortgages and
other real estate loans); business loans (commercial and industrial loans); and consumer
loans.

From the view point of banks, loans are less liquid than other assets. Unlike securities, a
loan cannot be cashed in before it comes due. Loans also have a higher default risk than
other assets do. In compensation for their lower liquidity and higher risk, loans yield the
highest rate of return among bank assets. When economic activity strengthens the ration
of bank loans to total bank assets increases and bank profits rise.

Real estate loans include long-term mortgages on residence properties, farms, and
business properties; short-term loans to building contractors, which are generally paid off
when the property is completed and sold; and home equity loans. Real estate loans are
relatively illiquid and involve both interest rate risk and default risk. Banks that issue
fixed-rate mortgages are at risk in the event that interest rates rise significantly after the
loans are made. The default risk in real estate loans is attributable to the fact that while
most of these loans are collateralized by the property being financed, real estate values

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can change sharply. During 1990-1992 many U.S. banks suffered major losses on
commercial real estate loans, and some became insolvent as a result. Banks have taken
steps to reduce the risk involved in real estate loans by issuing variable-rate mortgages
and by "scrutinizing" mortgages that is bundling individual mortgages into packages and
selling them to large investors such as pension funds and life insurance companies.

Relative to other financial intermediaries such as life insurance companies, banks have a
comparative advantage in making business loans. Their familiarity with business
depositors allows them to do careful evaluation and monitoring of potential borrowers.
Banks consider business loans to be high-priority items. Because a large portion of all
demand deposits in banks are held by businesses bankers feel a strong need to
accommodate reasonable loan requests from established businesses in order to retain their
deposit accounts and maintain a reputation as a reliable source of funds. Small and
midsize banks lend heavily to local businesses.

Many banks extend a line of credit to their business customers. This arrangement enables
a business firm to obtain frequent short-term loans. The bank makes a loan commitment
to the firm, typically allowing the firm to borrow on demand. In exchange for this
valuable privilege, the customer is commonly required to maintain a compensating
balance that is, a non interest-bearing checking account averaging perhaps 10 percent of
the line of credit. A compensating balance raises the cost of the arrangement to the
business customer and compensates the bank for the risk involved in guaranteeing a
ready source of funds at all times.

Business loan demand exhibits a marked pro cyclical pattern, rising during economic
expansions and declining during recessions. During periods of economic expansion,
banks obtain funds to accommodate rising business loan demand by selling short-term
U.S. government securities, issuing negotiable CDs and engaging in non deposit
borrowing. During economic down turns, as loan demand declines, banks use the
proceeds of loan repayments to purchase government securities, redeem maturing
negotiable CDs and reduce other forms of bank borrowing.

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Banks grant loans to individuals, commonly known as consumer loans, through several
arrangements. Many consumer loans are for durable goods-automobiles, for example.
Others are general-purpose loans-for example, credit card loans. From the bank’s point of
view, consumer loans are generally more liquid than other types of loans. They tend to be
short term, and many are amortized-that is, part of each regular payment goes to reduce
the principal.

Credit card loans and overdraft arrangements, which grant on-the–spot loans to
individuals to prevent their checks from bouncing. Are some times known as “instant
credit privileges: Ushered in by the record-keeping efficiency of computers, these loans
are essentially an automatic line of credit to consumers. The first bank credit card was
Issued in 1952 by the Franklin bank of New York. A credit card, such as VISA or Master
Card. Gives a customer a preauthorized line of credit from the bank that issues the card,
the customer may also obtain cash advances from any of thousands of tanks that honor
the card. Overdraft privileges allow customers to obtain automatic credit when they write
checks in excess of their demand deposit balances. The bank grants a loan to the
customer in the amount of the overdraft, either by debiting the customer’s credit card or
by making an automatic direct loan.

Credit card loans are extremely portable for banks. First, the bank that issues the card
repays the merchant at a discount of anywhere from 2 to 5 percent of the value of
merchandise purchased, In addition, the interest rates that are charged on credit card
balances are often extremely high. As a result, banks typically earn a return on credit card
loans more than 10 percentage points higher than the interest rates on U.S. Treasury bills.
Given that loan losses on customer balances have averaged less than 3percent in recent
years, credit cards are a lucrative business for banks.

Other types of loans granted by banks include loans to financial institutions; loans to
dealers, brokers, and individuals to purchase or carry stocks; loans to farmers; and federal
funds sold. The latter item refers to commercial bank deposits at the Federal Reserve,
which have been loaned to other banks. (Its counterpart. "Federal funds purchased," is
included in the liability item "borrowings"

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1.7.3 Securities
Securities are an important item on the bank balance sheet, accounting for almost one
fourth of bank assets and contributing approximately 15 percent of bank income. This
item consists entirely of debt instruments because banks are not permitted to purchase
corporate stocks. Among the securities, or "investments," banks hold are U.S.
government and government agency securities, and state and local government bonds.

U.S. government and agency securities are highly liquid because of the well developed
market in which they are traded. Because they are issued by the federal government, they
are safe from the risk of defaults. However, they are subject to market risk the risk that
interest rates may rise, causing a decline in the price of the securities. Some banks got
into trouble in the late 1970s and early 1980s as interest rates rose dramatically and the
prices of their bonds took a beating. However, most U.S. government securities help by
banks today have short-term maturities and are therefore subject to only modest price
fluctuations. The market risk of these securities is minimal.

State and local government securities have a tax advantage for banks: interest in come
earned on them is not taxable by the IRS. Another reason banks purchase them is that
state and local governments are more likely to do business with banks that hold their
securities. But these securities are riskier than U.S. government securities because state
and local governments sometimes default on their obligations. For this reason, state and
local government bonds have a higher after tax return than U.S. government securities do.
In recent years the portion of total bank assets allocated to state and local government
bonds has declined significantly.

Compares the long-term trend in the ratio of bank security holdings to total bank assets
with the long-term trend in the ratio of bank loans to total bank assets. In the late 1940s,
government and agency securities made up nearly 50 percent of total commercial bank
assets. By 1980 that figure stood at less than 20 percent. A security declined in
importance loans assumed a more important role.

The long-term decline in the role of securities in bank assets is explained by the long-
term increase in the demand for loans together with the advent of alternative sources of

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liquidity available to banks other than short-term securities. In general, loans are more
profitable than securities. in the 1940s and 1950s, banks held massive quantities of
government securities, largely because loan demand was limited and because short-term
securities are highly liquid that is, they can be cashed in with minimal risk of loss of
principal when banks need funds for loans and other purposes. Since the 1950s, loan
demand has risen and banks have increasingly gained access to other sources of liquidity
besides the sale of securities. They have borrowed federal funds, issued negotiable CDs,
and adopted other innovative techniques to obtain funds as needed. These changes
explain the declining role of securities in banks' asset structure. Note. however, that the
long-term trends of the two asset ratios reversed direction in the late 1980s.

Besides their long-term trend, bank security holdings exhibit a distinct cyclical pattern.
Government security purchases are a residual use of bank funds. During the expansion
phase of the business cycle when loan demand is rising, banks typically sell short-term
government securities to obtain funds to lend to worthy borrowers. During economic
contractions, as loan demand declines banks purchase U.S. government securities for
income.

1.7.4 Other Assets

Other bank assets include the physical assets of a bank- bank building, computers,
automatic teller machines, and other equipment. Also included in this category is the
collateral the bank has repossessed from borrowers in default.

1.8 COMMERCIAL BANK CAPITAL ACCOUNTS

Listed beneath "other liabilities" on the aggregated bank balance sheet is bank capital, or
capital accounts. The difference between total assets and total liabilities, it is the bank's
net worth the equity stake the owners have in the bank. Bank capital derives from the
issue of stock in the bank and from retained earnings profits earned by the bank that are
not paid out to the owners (stockholders). In March 1996, bank capital was reported to be
8.3 percent of total assets on a historical basis, an exceptionally high figure, reflecting the
robust financial condition of banks in the mid 1990s.

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Bank capital provides a cushion against a contraction in the value of a bank's total assets,
which could result in insolvency. A bank becomes insolvent when the value of its total
assets drops below the value of its total liabilities. When that occurs the regulatory
authorities either close the bank or arrange for new owners and managers to come in. In
this case the original owners lose their equity stake in the bank.

Consider the balance sheet of the Bank of Muddy Gap (Wyoming) before and after the
regulatory authorities force the bank to write off $600,000 worth of bad loans to ranchers.
Before the bad-loan write off, the bank had $11 million of total assets and $10.5 million
of total liabilities so its capital was (positive) $0.5 million.
Bank of Muddy Gap Bank of Muddy Gap
(Before loan write-off) (after loan write-off)

Assets Liabilities Assets Liability

Cash assets 1.0m Deposits 10.0m Cash assets 10.m deposits 10.0m
Loans 7.0m Other liab. 0.5m Loans 6.4m Other liab. 0.5m
Securities 2.0m Total liab. 10.5m Securities 2.0m Total liab. 10.5m
Other assets 1.0m Capital 0.5m Other assets 1.0m Capital –0.1m
Total liab. Total liab.
Total assets 11.0m and capital 11.0m Total assets 10.4m and capital 10.4m

Note that when the bank writes off the bad loans (right-hand balance sheet), its loans
decrease by the amount of the write-off. Given that there is no change in the bank's total
liabilities the bank's capital account also decreases by the amount of the write-off ($0.6
million). Because the capital accounts are now negative ($0.1 million) the bad loan write
off has forced the Bank of Muddy Gap into insolvency. The regulatory authorities will
move in and close the bank or sell it to new owners.

Frequently, by the time the regulatory authorities have closed insolvent bank its net worth
has become significantly negative. Because the Federal Deposit Insurance Corporation
(FDIC) insures deposits up to $100,000, bank capital may be regarded as a cushion that
protects depositors with accounts of more than $100,000 as well as the FDIC (and

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therefore taxpayers). We will discuss the management of bank capital later in this
chapter.

1.9 COMMERCIAL BANK MANAGEMENT

Commercial banks are business firms; like all firms, they strive to earn a profit. The
object of commercial bank management is therefore to maximize profits while
maintaining a very low risk of becoming insolvent. To remain solvent, a commercial
bank must take precautions to ensure that the value of its assets exceeds the value of its
liabilities at all times. If at any time losses from securities, defaulted loans or other
investments force the value of the bank's assets below the value of its liabilities, the bank
becomes insolvent.

A bank is considered solvent if it could in an orderly manner perhaps over several weeks
sell its assets and obtains sufficient revenues to meet its liabilities. Solvency must be
distinguished from liquidity, which refers to a bank's immediate ability to meet currency
withdrawals, check clearings, and new loan demand while abiding by the reserve
requirements. To maintain bank solvency, banks must employ skillful liquidity
management and capital management. In the remainder of this chapter, we will discuss
those tools, along with the techniques of liability management.

1.10 LIQUIDITY MANAGEMENT

Let's begin our discussion of liquidity management by illustrating the effect of the
withdrawal of currency and the clearance of checks on the bank balance sheet and the
bank's reserve position. To do this, we will use T-accounts, which are statements of the
change in a balance sheet resulting from a given event. (Rather than showing the balance
sheet both before and after the event, we will simply indicate the change in the balance
sheet by using a T-account)

Suppose a customer withdraws $200 in cash from a savings account at the Bank of
Medicine Bow, Wyoming. The T-account would indicate the balance sheet change as
follows:

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 Bank of Medicine Bow

Cash 200 Savings deposits 200

The bank simply presents the customer with #200 worth of currency and debits the
savings account by $200. The bank's reserves (cash plus deposits at the Fed) also decline
by $200, because the withdrawal of currency from a bank reduces its reserves on a dollar-
for-dollar basis. Unless the bank was initially holding excess reserves - reserves above
and beyond the required amount- it is now short on reserves and will have to take
measures to obtain more reserves in order to abide by the Fed's reserve requirements.

A similar result occurs when a check written by a bank customer is cleared. Suppose a
customer of the Bank of Medicine Bow writes a check for $12,000 to a New York stock
broker to pay for newly purchased shares of stock. The Bank of Medicine Bow is a
member of the Federal Reserve System, so the check is cleared through the Fed's check
processing facilities. When the check has been processed and cleared the T-account for
the Bank of Medicine Bow appears as follows:

Bank of Medicine Bow

Deposit at Federal reserve 12,000 Demand deposits 12,000

How does this happen? The stockbroker deposits the check in the brokerage firm's
account in a New York commercial bank, which sends the check on to the Federal
Reserve. The Fed deducts the reserve account of the Bank of Medicine Bow by $12,000;
credits the reserve account of the New York bank by $12,000; and sends the check back
to the Bank of Medicine Bow. A that point, the Bank of Medicine Bow deducts the

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customer's demand deposit account by $12,000. The important point to note is that the
Bank of Medicine Bow loses reserves in the amount of the check that is $12,000. unless it
had excess reserves to begin with, it must take measures to replenish its reserve account.

To summarize, withdrawal of currency and/or clearance of checks written on a bank

reduces that bank's reserves by an equivalent amount. Conversely, the deposit of currency
and/or clearance of checks deposited into a bank increases the bank's reserves on a dollar-
for - dollar basis. According to the law of averages, one would remain roughly constant
over a given week or month. However, banks sometimes experience significant
fluctuations in their reserve positions.

The crucial questions facing bank management are the following: How severe is the
bank's exposure to significant reserve losses? What measures would the bank need to take
to remedy a prospective loss of reserves? If a bank has minimal exposure to reserve
losses or is in a position to recover a potential reserve loss easily without incurring
significant costs, it is probably in sound financial condition, even with a relatively small
capital account. On the other hand, if a bank is exposed to large deposit outflows and can
obtain reserves only at substantial cost, it may find itself in serious trouble even if it has a
large capital account. Banks that exhibit higher risk need larger capital accounts. We will
now examine the trade-off between liquidity and risk.

To see the importance of liquidity management, consider the following (simplified)

balance sheet of Imprudent Bank. Assume reserve requirement for deposits is 10 percent.

Imprudent Bank

Assets Liabilities
Reserves (cash +deposits
At federal reserve) 40m Deposits 400m
Marketable Securities 10m Capital accounts 40m
Loans 390m
Total assets 440m Total liabilities and capital 440m
Note that Imprudent Bank, with reserves of $40 million, just meets that 10 percent
reserve requirement. It holds deposits (DDO) of $400 million, so its required reserves are

19
$40 million (10% x $400 million). It has no excess reserves. In addition, it holds $10
million in marketable U.S. government securities and #390 million worth of loans.
Because loans provide a higher rate of return than securities. Imprudent Bank has been
tempted into allocating an extremely high proportion of its total assets to loans. The right
hand side of the balance sheet indicates that the bank has capital in the amount of $40
million, which represents a solid capita-to-assets ration 9.1 percent.

Now, suppose rumors circulate that a large portion of Imprudent Bank's loans are in
trouble due to server problems in the real estate sector, to which the bank ahs made large
loans. Some depositors with more than $100,000 (the FDIC insurance ceiling) in their
accounts are likely to withdraw their deposits. suppose those depositors withdraw 5
percent of the bank's total deposits, or $20 million, by writing checks on their demand
deposits.

The new balance sheet for Imprudent Bank is as follows:

Imprudent Bank

Assets Liabilities
Reserves 20m deposits 380m
Marketable securities 10m Capital accounts 40m
Loans 390m
Total assets 420m Total liabilities and capital 420m

Note that Imprudent Bank's reserves have dropped to $20 million, while required reserves
are now $38 million (10% x $380million). The bank is thus $18 million short on reserves.
Though it can sell off its marketable securities to gain an additional $10 million of
reserves, it will still be $8 million short of meeting the Fed's reserve requirements.

The bank must now attempt to again $8 million of additional reserves, either by
redeeming its loans or by borrowing funds through the liability side of its balance sheet.
Both these option are likely to be difficult and costly. To the extent that the rumors are
widespread, Imprudent Bank may have difficulty borrowing funds. Would you lend to a
bank you suspect will fail? And bank loans are relatively illiquid assets they are

20
contractual agreements that typically cannot be called in before they come due. The bank
has the option of selling its loans to other banks. However, because of informational
problems, it is likely to have to sell the loans at prices significantly lower than their true
value. If that is the case, the bank will take a loss a dollar-for-dollar hit against its capital
account. Such a loss, added to the bad loans (assuming the rumors were true), increases
the likelihood that the bank will become insolvent and will be closed or sold to new
owners.

Imprudent Bank was tempted to take big risks in order to achieve the greater profitability
associated with allocating a high proportion of total assets to loans. In the next section,
we will consider the trade-off between liquidity and profitability.

Now, consider the balance sheet of Prudential Bank, a highly conservative, cautions
institution:

Prudential Bank
Assets Liabilities
Reserves 50m Deposits 400m
Marketable securities 190m Capital accounts 40m
Loans 1200m
Total assets 440m Total liabilities and capital 440m

This bank is probably excessively concerned about liquidity. It has exactly the same
amount of liabilities and capital as Imprudent Bank but exhibits a much more liquid as set
structure. Prudential Bank has $10 million worth of excess reserves ($50 million- 10% x
$400 million) and a huge portfolio of marketable securities. In other words, it has lost of
secondary reserves, or excess reserves and interest bearing liquid assets that can quickly
and conveniently be converted into actual reserves that is, cash and deposits at the
Federal Reserve.

Now suppose the rumors about bad loans that brought down Imprudent Bank circulate
about Prudential Bank as well. Depositors withdraw $20 million, but Prudential Banks till
has $30 million in reserves. Since its required reserves are no $38 million, it is short only

21
$8 million and can easily liquidate a small portion of its marketable securities to obtain
enough reserves to meet the reserves requirement. Prudential will not have to sell off any
loans and is clearly in a better position to handle the rumors than Imprudent was. If
necessary, prudential could write off up to 20 percent of its loan portfolio and still remain
solvent. In contrast, write-offs of slightly more than 10 percent of Imprudent Bank’s
loans would bankrupt that institution.

Prudential Bank, in its obsession to minimize risk, has limited its own profit by
maintaining a large amount of excess reserves, which earn no interest, and an unusually
low proportion of loans to total assets. (Remember that loans earn a higher rate of return
than securities.) This example illustrates the trade-off between liquidity and profitability.
Contrast this with Imprudent Bank, which in its single-minded quest for profit maintains
an illiquid and highly risky asset structure, with almost 90 percent of its assets in loans. In
normal and good times, Imprudent will earn a higher profit than prudential Bank.
However, it is perilously exposed to insolvency in the event that a significant portion of
its loans turn sour. Most real-world banks maintain a balance sheet somewhere between
the extremes exhibited by Imprudent Bank and Prudential Bank.

There are several indicators of the liquidity of the commercial banking system. One is the
ratio of bank loans to total assets, along with the corresponding ratio of securities to total
assets. The higher the loans to total assets ratio, given other factors, the more illiquid is
the banking system. (Which shows the trend of this ratio. )Another indicator is the ratio
of cash assets to total assets. The higher this ratio, given other factors, the more liquid the
banking system.

Both these indicators point to a decline in bank liquidity over the past 50 years. Bank
loans as a percentage of total assets have increased from 30 percent in the 1950s to
approximately 60 percent today. Cash items have declined from about 20 percent of total
assets in the 1950s to approximately 5 percent tosay.10 on the other hand, the need for a
highly liquid bank asset structure has also declined for at least two re seasons. First. The
share of total bank deposits constituted by demand deposits has declined sharply over the
past 35 years, from approximately 70 percent in 1960 to roughly 30 percent today. With a
larger share of bank funds coming from savings and time deposits, which have relatively

22
low turnover rates, banks require less liquidity in their asset structure than formerly.
Second. Since 1960s banks have been able to turn to the liability side of the balance sheet
to obtain liability when needed. In the nest section. We turn to the topic of bank liability
management.

Consider the balance sheet of two banks, HC Bank and LC bank, and answer the
following questions.

a. What is the capital to total assets ratio of each bank?

b. Which bank exhibits a more liquid structure?
c. Over time, which bank is likely to exhibit greater variance in its deposits and
reserves?
d. Which bank do you suppose would cause more concern to the regulatory
authorities?

HC (High-Capital) Bank
Assets Liabilities
Cash assets 10m Demand deposits 80m
Short-term securities 5m Savings depo9sits 15m
Long-term bonds 25m Small time deposits 5m
Loans 70m Capital accounts 10m
Total assets 110m Total liabilities and capital accounts 110m

LC (Low-Capital) Bank
Assets Liability
Cash assets 20m Demand deposits 30m
Short-term securities 25m Savings deposits 20m
Long-term bonds 25m Small time deposits 50m
Loans 35m Capital accounts 5m
Total assets 105 Total liabilities and Capital accounts 105m

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Liability Management
Before the 1960s, banks took their liabilities as essentially given. Prohibitions on the
payment of interest on checking accounts, together with statutory ceiling on interest rates
payable on savings and time deposits prevented banks from competing aggressively for
deposits. Furthermore, the federal funds, market was relatively undeveloped, and
negotiable CDs and repurchase agreements had not yet been conceived. other than
mounting advertising and marketing campaigns, there was little banks could do to gain
additional funds at their own discretion. Banks pretty much passively accepted deposits
and they made decisions on how to allocate these funds among cash assets, loans and
securities. Banks practiced asset management but not liability management.

Starting in the 1960s and accelerating more recently, banks began to look for good
lending opportunities and then to search for the funds to finance these loans. Today, when
a large bank finds a profitable loan opportunity, it can obtain funds through several
techniques. One is to "buy" federal funds that is, borrow the reserve deposits of other
banks held by the Federal Reserve. Another is to issue negotiable CDs at whatever
interest rate is require to attract funds. Banks can also issue repurchase agreements or
borrow Eurodollars (dollars denominated in European or Caribbean banks or foreign
branches or U.S. banks). Finally, banks can obtain funds via the commercial paper
market, though their large bank holding companies. To a lesser extent, even midi sized
and relatively small banks can practice liability management, either through the federal
funds market or by biding for brokered deposits pieces of large negotiable CDs that have
been broken down into fully insurable $100,000 blocks for placement throughq1money
brokers.

Today, many large banks target a certain growth rate for total assets. They then search for
profitable lending opportunities and practice aggressive liability management to obtain
the funds to make the loans. Banks find liability management desirable inasmuch as it
permits them to make profitable loans that the would otherwise have to turn down. This
liability management contributes strongly to bank profits the growth of liability
management by banks is indicated by the fact that, between 1965 and 196,thfe volume of
negotiable CDs outstanding increased from $20 billion to more than $400 billion.

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Yet there are damagers inherent in aggressive liability management. Because bank’s
assets typically have longer maturities than their liabilities, banks can suffer severe losses
in the event that interest rates rise sharply. And if unfavorable rumors about a bank’s
financial condition begin to circulate, a bank’s sources of funds may dry up quickly as
large depositors cut and run. This phenomenon contributed to the failure of the
continental Bank of Illinois in 1984.

Despite Continental’s experience, some banks act as if liquid funds can be borrowed as
needed, almost without limit. They see little need to hold marketable short-term
securities. But the huge cash shortages experienced in recent years by some banks make
clear the fact that liquidity needs cannot be Ignored, in fact, the regulatory authorities
sometimes close a bank because of liquidity problems. Even though it is technically
solvent. In 1991, for example, the Federal Reserve closed the $ 10 billion southeast bank
of Miami when it failed to come up with a sufficient cash to repay loans it had taken out
from the Fed.

The emergence of liability management has complicated the task of the Federal Reserve,
For example, the Fed sometimes attempts to slow aggregate expenditures in periods of
excessively storing economic activity by implementing restrictive monetary policy
actions. If banks scramble to issue additional liabilities to fund surging loan demand. The
Fed’s ability to control aggregate expenditures is compromised. At such times, the Fed
has sometimes imposed reserve requirements on certain managed liabilities in an effort to
curb banks’ attempts to circumvent its intentions.

Capital Management
As was indicated earlier, bank capital provides banks with a financial cushion, so that
short-term setbacks will not cause them to become insolvent. Essentially, bank capital
serves to protect large uninsured depositors and the FDIC. But bank capital also protects
bank managers and owners from their own folly. Reasonable mistakes can be made with
out wiping out owners’ equity and terminating managers’ careers.
Banks are exposed to several types of risk, first is default risk-the risk that a loan (or the
interest thereon) will not be repaid or that a municipality will default on its bonds. Second

25
is interest rate risk, or the risk that interest rates may raise after securities have been
purchased, depressing the prices of the securities. And because bank assets typically have
longer maturities than bank liabilities, higher interest rates can increase the cost of funds
without commensurately increasing the return earned on assets, impairing the bank’s
profits. Third, banks are subject to liquidity risk, the risk that depositors may pull their
funds out. Fourth, the banks doing business across national borders are sometimes
exposed to foreign exchange rate risk-the risk that exchange rat is may move in a way
that causes losses to banks. Fifths, large banks with loans and investments abroad assume
political, or country risk, which involves the possibility that a bank’s funds or assets
outside the United States may be confiscated or otherwise prevented from being returned
to the United States. Finally, as several recent scandals have attested banks are
increasingly subject to what might be called management, or supervisory risk-the risk
that certain bank employees, in an era of almost incomprehensible financial technology,
might, unknown to upper management and owners, enrage in activities that involve
enormous risk.”

Some of these risks can be hedged, at a cost, through derivatives and other financial
instruments; other risks cannot. Banks knowingly take legitimate risks in order to earn an
attractive rate of return. In fact, a fundamental principle of finance is that riskier
investments bring higher expected rates of return. A bank that is exceedingly risk averse
will earn a low profit and may alienate customers by denying them legitimate loans.

The predominant cause of bank insolvency stems from bad loans. Loans that appear
sound when they were made are sometimes rendered bad by changing economic
conditions. For example, when oil prices collapsed in late 1985,thousands of loans made
by Texas banks went into default as the dramatic decline in oil revenues rippled through
the Texas economy, closing businesses and throwing people out of work, Hundreds of
Texas banks failed in the following few years.

Given other factors, the higher a bank’s capital to total assets ratio, the lower its risk of
insolvency. On the other hand, the higher its capital ratio, the lower the rate of return

26
earned by the bank’s owners (the owners’ equity is the capital account). Consider the
following identity:

(9-1) Earnings = Earnings x Total assets

Equity capital Total assets Equity capital

The left-hand side of the expression is the percentage rate of return earned by the bank’s
owners on their capital, or owners’ equity: it is known as the rate of return on equity, or
rate of return on capital. The first expression on the right-hand side is the rate of return
earned on total assets. It is an indicator of the bank’s efficiency, because it shows the
profit earned per dollar of assets. The final expression, the ration of total assets to equity
capitals, is sometimes known as the equity multiplier. It is simply the reciprocal of the
bank’s capital accounts to total assets ratio and expresses the amount of leverage that is
applied to the rate of return on tot al assets. A high capital to total assets ratio represents a
low equity multiplier; a low capital to total assets ratio implies a high equity multiplier.

Supposed a bank earns an annual profit of 1 percent of its total assets-approximately the
average return earned by U.S. banks over the past 5 years. If the bank has a capital to
total assets ratio of 5percent (an equity multiplier of 20), Equation 9-1 indicates that it
will earn a rate of return on equity of 20 percent per year (10%x20). Alternatively, if the
capital to total assets ratio is 10 percent, the rate of return on equity will be only 10
percent per year (1%x10). A higher capital accounts ratio has both benefits and cost.
Though it reduces the risk of insolvency, it also reduces the rate of return earned by the
bank’s owners. Clearly, there is a trod-off between short-run profitability and the risk of
insolvency, a trade-off that every bank must grapple with. Shows the rates of return U.S.
banks have earned on total assets and equity capital over the years.

Our analysis suggests that for each bank there is some optimal ratio of capital to total
assets. This optimal ratio depends n the nature of the bank’s assets and liabilities and may
vary over time with economic conditions. For example, when a period of financial
distress looms ahead, a prudent bank will take steps to increase its capital ratio.
A bank that wants to increase its capital to total assets ratio has three choices. First, it can
increases retained earnings by reducing dividend payouts to the bank’s owners. Second, it

27
can issue new shares of stock. Third, it can shrink total assets by selling securities and
reducing loans, and use the proceeds to reduce borrowings or other liabilities. Unlike the
first two choices, the third does not increase bank capital. However, by reducing the total
assets of the bank, it increases the capital to total assets ratio.

In the early 1990s, in the wake of anemic bank profits and depressed stock prices, many
banks employed this third option. Major U.S. banks had suffered large loan losses in the
late 1980s and early 1990s. Bank insolvencies had soared from an average of 6 per year
during 1960-1979 to 150 per year during 1984-1992. Regulatory authorities reacted in
part by imposing strict capital standards, which forced thousands of banks to increase
their capital ratios. They reduced their lending in order to bolster their capital ratios and
comply with tightened federal standards, creating what has been called a “capital credit
crunch” in the process. Bank loans became unusually difficult to obtain, as thousands of
banks tightened their lending standards. Since then, the robust profits earned by banks
during the economic expansion of 1992-1996 have further raised the bank capital ratios.
Today, U.S. banks are in much stronger financial condition than they were in the 1980s
and early 1990s.

In closing, we must not that the cost to society of a bank failure exceeds the cost born by
the failed bank, when a bank fails, large depositors and the FDIC insurance fund
frequently incur losses (banks are seldom closed before the capital accounts become
significantly negative). For this reason, the capital ratio deemed optimal by banks is
lower than the ratio that is optimal from societies viewpoint. Many economists there for
support the imposition of binding capital standards on banks by regulatory authorities.
We will have more to say on this issue in chapter 11.

Check your progress

1. List three sources of and three uses for commercial bank funds.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
2. Why have cash items and securities decreased as a proportion of total bank assets
over the past 40 years? What has taken their place, and why?

28
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
3. Distinguish bank solvency from bank liquidity.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
4. Explain the conditions that caused the emergence of NOW accounts, repurchase
agreements, and ATS accounts. Why are such innovations more likely to occur in
a period of high inflation and interest rates?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
5. Why does the volume of negotiable CDs outstanding move procyclically?
procyclically
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………

29
1.11 SUMMARY

Commercial banks as the dominant type of financial intermediary. Are key players in the
U.S. Financial system they take in funds by Issuing deposits, borrowing from sources
other than depositors and obtaining equity funds from then owners. They use these funds
primarily to purchase federal state, and local government securities and to extend loans to
businesses. Consumers. And other bonders a sound banking system is essential to the
nation’s economic health. To maintain solvency, banks practice liquidity management
and capital management. Although highly liquid assets such as U.S. Treasury bills yield
low rates of return, banks hold them to protect against the cost of adjusting to deposit and
currency outflows and the accompanying loss of reserves. Although a higher ratio of
capital to total assets refuses the rate of return on equity for bank owners, higher capital
ratios provide a larger cushion to reduce the risk of bank insolvency. In the past 20 years.
The nation’s banks have been challenged by financial innovations. Macroeconomic
shocks, and other events. In the late 1980s and early 1990s. Banks financial conditions
deteriorated and more than one thousand commercial banks failed, however, since the
1990-1991 recession, both the income statements and the balance sheets of the nation’s
commercial banks have strengthened dramatically.

1.12 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. The three sources:

 Deposits
 Non-deposits borrowings
 Capital

The three uses of funds are:

 Reserves
 Loans
 Securities
2. It is favorable to the banks profitability

30
 The reasons for such decrease of cash items as a proportion of total bank assets
are:
 Reduction in reserve requirements
 Large reduction in demand deposits and checkable deposits
 Large reduction in Bank liabilities subject to reserve requirement
3. A bank is considered solvent if it could sell its assets and obtain sufficient
revenues to meet its liabilities.
Solvency is different from liquidity
Liquidity refers to banks immediate ability to meet currency withdrawals, check
clearings and new loan demand while abiding by the reserve requirements.
4. Transactions deposits are the lowest-cost source of bank funds. Included in this
category are demand deposits, which are non-interest bearing checking accounts.
Other types of checkable accounts do pay interest. Included are negotiable order
of withdrawal (NOW) accounts, automatic transfer service (ATS) accounts, and
money market deposit (MMD) accounts. While individuals and non-profit
organizations may hold both demand deposits and other types of checkable
deposits, regulations prohibit banks from issuing NOW, ATS, or MMD accounts
to business firms. That is, profit-oriented business firms are not allowed to hold
interest bearing checking accounts in banks.

Thus, a NOW account is essentially a savings account on which checks may be

written. Though lobbyists for banks won an early ruling prohibiting the spread
of NOW accounts beyond New England, in 1980 the Depository Institution
Deregulation and Monetary Control Act (DIDMCA) authorized nation wide
issuance of NOW accounts.

At the same time that NOW accounts were legalized nationwide, a similar
instrument, the ATS account (automatic transfer service), was authorized. With
an ATS account, the customer maintains a minimal checking account balance
and holds additional funds in an interest-bearing savings account. As checks
drawn on the checking account are presented for clearance the bank's computer
automatically transfers sufficient funds from the individual's savings account to

31
 the checking account to permit checks to clear and maintain the minimum
checking account balance. Like the NOW account, the ATS account is
essentially an interest bearing checking account.

5. Large negotiable CDs are issued in minimum denominations of $100,000 and are
typically purchased by corporations and money market mutual funds as an
alternative to short term government securities. Issued in specific maturities, they
provide a reliable source of funds for the large well-known banks that issue them.
While negotiable CDs are not redeemable prior to maturity by the bank, they may
be traded in an active secondary market and are therefore highly liquid.

The volume of negotiable CDs outstanding fluctuates with economic conditions.

When credit demands escalate during an economic expansion and the Federal
Reserve moves to restrain bank lending, the volume of negotiable CDs tends to
escalate. From 1989-1992, as the U.S. economy softened and credit demand
declined the volume of negotiable CDs outstanding declined by more than 25
percent. As the economy strengthened in 1994 and 1995, the volume of negotiable
CDs increased 25 percent.

1.13 MODEL EXAMINATION QUESTIONS

1. List three sources of and three uses for commercial bank funds.
2. Why have cash items and securities decreased as a proportion of total bank assets
over the past 40 years? What has taken their place, and why?
3. What is meant by a commercial bank’s capital accounts? Suppose a bank wants to
increase its capital by $1 million. How could it do so?
4. This Christmas. You decide to buy your true love as partridge in a pear tree. After
consulting with several garden centers. You make your purchase by writing a
check for $150. The garden center probably deposits your check in its bank.
a. Using T-accounts. Show the effects of this transaction on your bank and
on the garden center’s bank.
b. What happens to your bank’s reserves? To the reserve of the garden
center’s bank?

32
 c. Assuming the reserve requirement is 10 percent and your bank was
holding no excess reserves initially, what is the level of excess reserves in
your bank after the transaction?
d. List four possible methods your bank can employ to remedy its reserve
deficiency.
5. “The ratio of capital accounts to total assets is only one of many factors that
indicate the financial condition of a commercial bank.” Evaluate this statement.
6. Your bank has total assets of $220 million loan package to Central American
nations will be written off as bad loans will your bank survive this crisis? Explain.
7. Distinguish bank solvency from bank liquidity.
8. From the point of view of an asset manager, discuss the trade-offs among the
objectives of safety, liquidity, and profitability.
9. What is meant by liability management? Discuss the instruments that banks use in
liability management. What are the advantages and potential pitfalls of liability
management for commercial banks?
10. Explain the conditions that caused the emergence of NOW accounts, repurchase
agreements, and ATA accounts. Why are such innovations more likely to occur in
a period of high inflation and interest rates?
11. Why does the volume of negotiable CDs outstanding move procyclically?
12. The growth of several movement agencies (FNMA, GNMA, and so forth) has
produced a liquid secondary market in mortgages. What has been the impact of,
these developments on
i. Mortgage rates?
ii. The risks borne by mortgage lenders?
iii. The composition of commercial bank loan portfolios?
13. Many banks in your community have been contacted about participating in a large
syndicated loan arrangement. Your bank has been invited to participate but does
not haven enough excess reserves to meet the terms of the agreements. How
might your bank raise the funds to participate in the deal?
a. Through asset management?
b. Through liability management?

33
14. Why might the FDIC and bank stockholders have different opinions of the merits
of maintaining a high capital accounts ration? Discuss the trade-offs involved.
Can you illustrate those trade-offs with a numerical example?
15. Bill’s bank and Ted’s bank have dramatically different liability structures. Bill’s
bank, located in an affluent neighborhood, raises funds by issuing small time
deposits to neighborhood residents. Ted’s bank, located in a working-class
neighborhood, issues mostly checking accounts to its customers. How might you
expect the portfolio of assets held by Bill’s bank to differ from that held by
Ted’s? Explain.

34