10. THE BANKING BUSINESS
We study the business of banking by examining a bank’s assets, liabilities, and capital.
Then we examine several bank scenarios to show how outside factors influence a bank’s balance
sheet. We record these changes by using a reduced balance sheet called T-accounts. For
example, we illustrate how a bank could become insolvent, while another scenario includes the
impact of interest-rate risk upon a bank’s balance sheet. Then we discuss how banks use
securitization to convert loans into marketable securities and how this led to the 2008 Financial
Crisis. Furthermore, students must understand Chapter 10 to understand the next chapter
because Chapter 11 examines the Federal Reserve’s balance sheet, and the public and banking
system influence over the money supply.
A Bank’s Balance Sheet
Checking and savings accounts are very popular in the United States. U.S. households
invest nearly 1/4 of their wealth in banks. They make payments by using checks that transfer
money from one bank and to another bank. One reason behind the popularity of bank accounts is
the federal deposit insurance. If a bank bankrupts and customers cannot withdraw cash from
their bank accounts, then the federal government will step in and pay the depositors their
accounts. Deposit insurance guarantees each customer will not lose a maximum of $250,000 if
his or her bank fails.
A balance sheet is a financial statement that lists all the bank’s assets and liabilities. Assets
are things a bank owns, while liabilities are things a bank owes to other people. Accountants list
assets on the left and liabilities on the right. Subsequently, accounting transactions conform to
the Equation 1.
Total Assets = Total Liabilities + Capital ( 1 )Capital equals total assets minus total liabilities. Capital has many names, such as net
equity, net worth, or net assets. If the business is a corporation, then we call this capital –
stockholders’ equity.
Liabilities are the first item on a bank’s balance sheet. They are the source of funds for a
bank with the most important being deposit accounts. Referring to Table 1, people and
businesses held $8.1 trillion in deposits. Then checking accounts become one the most important
deposit accounts. For example, if you needed money and went into a bank, the bank must allow
you to withdraw money from your checking account immediately on demand. Consequently,
checking accounts become a liability to the bank because the bank owes you this money.
Moreover, checking accounts earn the lowest interest rate and are usually the cheapest source of
funds for a bank.
Non-transaction deposits are the second liability. These deposits include the various types
of savings accounts. These accounts earn interest and do not allow check-writing privileges.