Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Kenneth R. Szulczyk

Your Bank

Assets Liabilities

Required reserves $0 million
Excess reserves 0 million
Loans 90 million
Securities 0 million

Deposits $80 million

Bank Capital 10 million

Now your bank needs $8 million in required reserves. If your bank sold the loans, the bank
would sell the loans for a lower value than the bank’s book value. Furthermore, the other banks
do not know your bank’s borrowers, so these banks will buy the loans for a fraction of the loan’s
value, generating a substantial loss. Your bank could ask other banks for a loan, but other banks
may decline if they believe your bank will fail. Your bank could ask the Federal Reserve for a
loan, but the Fed may not grant the loan.
Your bank sells $40 million of loans, but the other banks will pay $25 million for them.
Now your bank became insolvent because total liabilities exceed total assets. Unfortunately,
your bank could fail. When a bank becomes insolvent, the U.S. federal government can legally
take control of the bank. The bank could have prevented its failure if the bank had more reserves
or more highly liquid securities. We display your insolvent bank’s balance sheet below.

Your Bank
Assets Liabilities
Required reserves $25 million
Loans 50 million

Deposits $80 million

Bank Capital 10 million

As you can see from the previous example, a bank could fail if too many loans go bad. A
bank is concerned about credit risk. Credit risk is a risk that borrowers will default on their
loans. One method banks use to lower credit risk is to diversify their loan portfolios. Banks
spread their loans across different industries, different regions, and different loan borrowers. For
example, a bank grants loans for credit cards, mortgages where the homes are spread across the
state, and commercial loans for hotels, restaurants, retail stores, and factories. If a factory
bankrupts and defaults on its commercial loan, the loan default does not harm the bank severely
because the bank is earning income on the other loans.
Adverse selection becomes a problem for banks. Some borrowers apply for bank loans,
when the borrowers know they will default. Banks implement six procedures to reduce adverse
selection, which include:

 Banks perform credit-risk analysis. Bank collects information about the borrowers’

employment, income, and net worth. From this information, the bank assesses the

borrowers’ ability to repay their loans.