Money, Banking, and International Finance- After the 2008 Financial Crisis, banks started accumulating more capital to deal with
future financial crises.
A Bank Failure.....................................................................................
A bank failure is a bank develops financial problems and fails. Unfortunately, the bank
cannot return the depositors’ money. A government imposes regulations to encourage banks to
hold a large amount of reserves, marketable securities, and equity capital, reducing a chance of
bank failure.
In this analysis, we use T-accounts. A T-account represents a simplified balance sheet
listing only changes for assets, liabilities, and net worth. For example, you open a checking
account at your bank and deposit $100 cash. We record the transaction below:
Your Bank
Assets Liabilities
+$100 Reserves +$100 Checking account
A central bank, for example, requires commercial banks to hold 10% of deposits in the form
of vault cash and/or reserves at the central bank. Therefore, $10 of your checking account
becomes required reserves while the remaining becomes excess reserves. Banks can lend their
excess reserves to borrowers, and we record the transaction below:
Your Bank
Assets Liabilities
+$10 Required reserves
- 90 Excess reserves
+$100 Checking accountBank earns no interest on reserves, so the bank grants a loan to a borrower for $90. Loan
becomes the bank’s source of income, and we record the transaction below:
Your Bank
Assets Liabilities
+$10 Required reserves
- 90 Loans
+$100 Checking accountFor the bank to earn a profit, the bank must earn a higher interest rate on the loan than the
level of interest the bank pays on your checking account. If a borrower defaults and does not
repay the loan, subsequently, the bank must return your $100, when you demand it. The bank
would pay $90 from the bank’s net worth and $10 from required reserves.
Banks face another complication, liquidity risk – the depositors withdraw more money from
their accounts than the amount of cash held in a bank’s vault. Consequently, banks developed
asset and liability management to prevent liquidity risk. Asset management is banks lend to