Bank Balance Sheets, Risk, and Monetary Policy

Posted on Mar 30, 2025 in Economy

Understanding the Balance Sheet

A Balance Sheet is a statement that shows an individual’s or a firm’s financial position on a particular day. The typical layout of a balance sheet is based on the following accounting equation:

Assets = Liabilities + Shareholders’ Equity.

An Asset is something of value that an individual or a firm owns, particularly a financial claim. A Liability is something that an individual or a firm owes, particularly a financial claim on an individual or a firm. Bank capital is the difference between the value of a bank’s assets and the value of its liabilities; also called shareholders’ equity.

Bank Assets Explained

Bank assets include:

• Reserves and Other Cash Assets:
  • Reserves are bank assets consisting of vault cash plus bank deposits with the Federal Reserve.
  • Vault cash is cash on hand in a bank (including currency in ATMs and deposits with other banks).
  • Required reserves are reserves the Fed requires banks to hold against demand deposit and NOW account balances.
  • Excess reserves are reserves banks hold above those necessary to meet reserve requirements.
• Securities: Liquid assets that banks trade in financial markets.
• Loans: The largest category of bank assets. There are three categories:
  • Loans to businesses: Commercial and industrial loans.
  • Consumer loans: Made to households primarily to buy automobiles and other goods.
  • Real estate loans: Residential and commercial mortgages.
• Other Assets: This category includes:
  • Bank’s physical assets (e.g., computer equipment and buildings).
  • Collateral received from borrowers who have defaulted on loans.

Bank Liabilities Explained

Bank liabilities include:

• Checkable deposits (or transaction deposits): Accounts against which depositors can write checks. Demand deposits are checkable deposits on which banks do not pay interest. NOW (negotiable order of withdrawal) accounts are checking accounts that pay interest. Checkable deposits are liabilities to banks and assets to households and firms.
• Nontransaction Deposits: The most important types are savings accounts, money market deposit accounts (MMDAs), and time deposits, or certificates of deposit (CDs). Federal deposit insurance is a government guarantee of deposit account balances up to $250,000.
• Borrowings: Bank borrowings include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and discount loans from the Federal Reserve System.

Constructing a Bank Balance Sheet

Key Bank Performance Metrics

A T-account is an accounting tool used to show changes in balance sheet items. Example: You open a checking account with $100 at Wells Fargo.

Net interest margin is the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.

A bank’s profits are commonly expressed in terms of its return on assets. Return on assets (ROA) is the ratio of the value of a bank’s after-tax profit to the value of its assets. Formula: ROA = After-tax profit / Bank assets.

To judge how much a bank’s managers are able to earn on the shareholders’ investment, we use the return on equity. Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to the value of its capital. Formula: ROE = After-tax profit / Bank capital.

ROA and ROE are related by the ratio of a bank’s assets to its capital: ROE = ROA x (Bank assets / Bank capital).

Leverage is a measure of how much debt an investor assumes in making an investment. Bank leverage is the ratio of the value of a bank’s assets to the value of its capital.

Managing Bank Risk Factors

Liquidity Risk Management

Liquidity risk is the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost. Banks reduce liquidity risk through strategies of asset management and liquidity management.

Credit Risk Management

Credit risk is the risk that borrowers might default on their loans. By diversifying, banks can reduce the credit risk associated with lending too much to a single borrower.

Credit-risk analysis is the process that bank loan officers use to screen loan applicants.

Historically, high-quality borrowers paid the prime rate. Today, most banks charge rates that reflect changing market interest rates instead of the prime rate. The prime rate was formerly the interest rate banks charged on six-month loans to high-quality borrowers (now an interest rate banks charge primarily to smaller borrowers).

Strategies to mitigate credit risk include:

• Collateral: Assets pledged to the bank in the event that the borrower defaults. Used to reduce adverse selection.
• Compensating balance: A required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank.
• Credit rationing: The restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. Loan and credit limits reduce moral hazard by increasing the chance a borrower will repay. If a bank cannot distinguish low- from high-risk borrowers, it risks losing low-risk borrowers when raising interest rates, leaving only high-risk borrowers (adverse selection).
• Monitoring and Restrictive Covenants: Banks keep track of whether borrowers are obeying restrictive covenants—explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities.
• Long-Term Business Relationships: Banks assess credit risks based on private information about borrowers. By observing the borrower, the bank can reduce problems of asymmetric information. Good borrowers can obtain credit at a lower interest rate or with fewer restrictions.

Interest-Rate Risk Management

Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital. A rise (fall) in the market interest rate will lower (increase) the present value of a bank’s assets and liabilities.

Gap Analysis

Gap Analysis is an analysis of the gap between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities. It is used to calculate the vulnerability of a bank’s profits to changes in market interest rates. Most banks have negative gaps because their liabilities (deposits) are more likely to have variable rates than their assets (loans and securities).

Duration Analysis

Duration Analysis is an analysis of how sensitive a bank’s capital is to changes in market interest rates. If a bank has a positive duration gap, then:

• The duration of the bank’s assets is greater than the duration of the bank’s liabilities.
• An increase in market interest rates will reduce the value of the bank’s assets more than the value of the bank’s liabilities, which will decrease the bank’s capital.

Reducing Interest-Rate Risk

Methods to reduce interest-rate risk include:

• Banks with negative gaps can make more adjustable-rate or floating-rate loans. If market interest rates rise, banks pay higher interest rates on deposits and also receive higher interest rates on their loans.
• Banks can use interest-rate swaps—agreeing to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan.
• Banks can use futures contracts and options contracts that can help hedge interest-rate risk.

Off-Balance-Sheet Activities

Off-balance-sheet activities are activities that do not affect a bank’s balance sheet because they do not increase either the bank’s assets or its liabilities. Four important off-balance-sheet activities banks rely on for fee income are:

1. Standby letter of credit: A promise by a bank to lend funds, if necessary, to a seller of commercial paper when the commercial paper matures.
2. Loan commitment: An agreement by a bank to provide a borrower with a stated amount of funds during some specified period.
3. Loan sale: A financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party.
4. Trading activities.

Investment Banks and Institutions

Investment Banking Activities

Investment banking involves financial activities such as underwriting new security issues and providing advice on mergers and acquisitions. Investment bankers are involved in:

• Providing advice on new security issues.
• Underwriting new security issues.
• Providing advice and financing for mergers and acquisitions.
• Financial engineering, including risk management.
• Research.
• Proprietary trading.

Underwriting is an activity where an investment bank guarantees the issuing corporation the price of a new security and then resells it for a profit, or spread. An Initial Public Offering (IPO) is the first time a firm sells stock to the public. A Syndicate is a group of investment banks that jointly underwrite a security issue.

Investment Institutions

An Investment institution is a financial firm that raises funds to invest in loans and securities. The most important are mutual funds, hedge funds, and finance companies.

Mutual Funds Explained

A Mutual fund is a financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks, bonds, mortgages, and money market securities. Mutual funds help reduce transaction costs, provide risk-sharing benefits, and gather information about different investments.

Types of mutual funds:

• Closed-end mutual funds: A fixed number of nonredeemable shares are issued, with the share price fluctuating with the market value of the assets.
• Open-end mutual funds: Investors can redeem shares after the markets close for a price tied to the value of the assets in the fund.
• Exchange-traded funds (ETFs): Market prices track the prices of the assets.
• No-load funds: Funds do not charge a commission, or “load.”
• Load funds: Funds charge buyers a “load” to both buy and sell shares.
• Index funds: Consist of a fixed-market basket of securities, such as the stocks in the S&P 500.

A Money market mutual fund is a mutual fund that invests exclusively in short-term assets, such as Treasury bills, negotiable certificates of deposit, and commercial paper.

Hedge Funds and Finance Companies

A Hedge fund is a partnership of wealthy investors that make relatively high-risk, speculative investments.

A Finance company is a nonbank financial intermediary that raises money through sales of securities and uses the funds to make small loans to households and firms. Main types: consumer finance, business finance, and sales finance firms.

Contractual Saving Institutions

A Contractual saving institution is a financial intermediary that receives payments from individuals as a result of a contract and uses the funds to make investments. Examples include pension funds and insurance companies.

Pension Funds Explained

A Pension fund is a financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide pension benefit payments during workers’ retirements. To receive benefits, an employee must be vested. Vesting is the number of years you must work to receive benefits after retirement.

The figure shows the investments of private and public pension funds. Both private and state and local pension funds concentrate their investments in stocks, bonds, and other capital market securities.

Employees prefer pension plans to personal savings for three reasons:

• Pension plans can manage a portfolio more efficiently and at a lower cost.
• Benefits such as annuities are expensive for individuals to obtain.
• The tax treatment of pension funds benefits the employee.

Types of pension plans:

• Defined contribution plan: The firm invests contributions for the employees who own the value of the funds in the plan. Most common today.
• Defined benefit plan: The firm promises employees a particular dollar benefit payment based on earnings and years of service.
• 401(k) plan: A specific defined contribution plan where an employee makes tax-deductible contributions through payroll deductions.

Insurance Companies Explained

An Insurance company is a financial intermediary specializing in writing contracts to protect policyholders from the risk of financial loss associated with particular events. Insurers obtain funds by charging premiums and use these funds for investments and direct loans (private placements).

Two types of insurance companies:

1. Life insurance companies: Sell policies protecting households against loss of earnings from disability, retirement, or death.
2. Property and casualty companies: Sell policies protecting households and firms from risks like illness, theft, fire, accidents, or natural disasters.

Life insurance companies have larger asset portfolios than property and casualty companies. Property and casualty companies hold more municipal bonds, while life insurance companies hold more corporate bonds.

Insurance companies use the law of large numbers (average occurrences for large groups) to make predictions. By issuing many policies, they benefit from risk pooling and diversification.

Shadow Banking and Systemic Risk

The “shadow banking system” consists of investment banks, hedge funds, and money market mutual funds.

Systemic risk is risk to the entire financial system rather than to individual firms or investors.

The Fed, Balance Sheet & Money Supply

The model of how the money supply is determined includes three actors:

1. The Federal Reserve: Responsible for controlling the money supply and regulating the banking system.
2. The banking system: Creates the checking accounts that are a major component of M1.
3. The nonbank public (all households and firms): Decides the form in which they wish to hold money (e.g., currency vs. checking deposits).

The money supply process involves these three actors. The Monetary base (or high-powered money) is the sum of bank reserves and currency in circulation.

Monetary base = Currency in circulation + Reserves

The money multiplier links the monetary base to the money supply. When stable, the Fed can control the money supply by controlling the monetary base. There’s a close connection between the monetary base and the Fed’s balance sheet.

Currency in circulation is paper money and coins held by the nonbank public. Vault cash is currency held by banks.

Currency in circulation = Currency outstanding – Vault cash

Bank reserves are bank deposits with the Fed plus vault cash.

Reserves = Bank deposits with the Fed + Vault cash

Understanding Bank Reserves

Reserve deposits are assets for banks and liabilities for the Fed because banks can request repayment on demand.

Reserves = Required reserves + Excess reserves

Required reserves are reserves that the Fed requires banks to hold. Excess reserves are reserves banks hold above the required amount. The Required reserve ratio is the percentage of checkable deposits the Fed specifies banks must hold as reserves.

How the Fed Changes the Monetary Base

The Fed changes the monetary base by changing its assets—through buying/selling Treasury securities or making discount loans.

Open market operations are the Fed’s purchases and sales of securities (usually U.S. Treasury securities) in financial markets, carried out electronically with primary dealers by the Fed’s trading desk.

• Open market purchase: The Fed’s purchase of securities.
• Open market sale: The Fed’s sale of securities.

A Discount loan is a loan made by the Fed to a commercial bank. Discount loans alter bank reserves and affect both sides of the Fed’s balance sheet. The Discount rate is the interest rate the Fed charges on discount loans, set by the Fed.

The monetary base (B) includes the nonborrowed monetary base (Bnon) and borrowed reserves (BR) (same as discount loans). The Fed controls the nonborrowed monetary base.

Multiple Deposit Creation Process

Multiple deposit creation is part of the money supply process where an increase in bank reserves results in rounds of bank loans and creation of checkable deposits. As a result, an increase in the money supply is a multiple of the initial increase in reserves. The Simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves.

Monetary Policy: Goals and Tools

Goals of Monetary Policy

The Federal Reserve has several main goals for monetary policy:

• Price stability: Keeping inflation low and stable.
• Full employment: Promoting maximum sustainable employment.
• Economic growth: Fostering sustainable and balanced economic expansion.
• Interest rate stability: Ensuring smooth functioning of financial markets.
• Exchange rate stability: Promoting stability in exchange rates.

Monetary Policy Tools

Discount Policy: The policy tool of setting the discount rate and the terms of discount lending. The Discount window is the means by which the Fed makes discount loans to banks, serving as a channel for meeting banks’ liquidity needs.

Reserve requirement: The regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

Federal funds rate: The interest rate that banks charge each other on very short-term loans, determined by demand and supply.

Supply of reserves: The supply curve for reserves shows how the Fed provides reserves via discount loans and open market operations. It’s initially vertical (Fed adjusts reserves independently of the rate) but becomes horizontal at the discount rate. If the federal funds rate drops below the discount rate, banks prefer borrowing from other banks (all reserves become non-borrowed). The discount rate acts as a ceiling on the federal funds rate because banks won’t pay more to borrow from other banks than they would from the Fed.

Open market operations: When the Fed conducts an open market purchase of Treasury securities, it increases their price, reducing their yield. This expands the monetary base, increasing the money supply. Conversely, an open market sale decreases the price of Treasury securities, increasing their yield, and contracting the monetary base and money supply.

Quantitative easing: A central bank policy attempting to stimulate the economy by buying long-term securities.

Categories of discount loans:

• Primary credit: Discount loans available for healthy banks experiencing temporary liquidity problems.
• Secondary credit: Discount loans for banks not eligible for primary credit.
• Seasonal credit: Discount loans to smaller banks in areas where agriculture is important.

Choosing Policy Instruments

When choosing between targeting reserves and targeting the federal funds rate, the Federal Reserve evaluates potential policy instruments based on three criteria:

• Measurable: Both reserve aggregates and the federal funds rate are easily measurable quickly, allowing accurate monitoring.
• Controllable: While not completely controlled (due to dependence on bank demand), the Fed’s trading desk can use open market operations to keep these variables close to targets.
• Predictable: The Fed seeks a policy instrument with a predictable effect on its goals, such as economic growth or price stability.