Bank Operation Basics

1. Learning Unit #17
Bank Operation Basics

2. Objectives of Learning Unit
Explore banking business through its balance
sheet:
– Bank balance sheet
– Bank operation and T-account
– Off-balance sheet activities

3. Balance Sheet
 Balance sheet: A list of the assets and liabilities.
 Assets: What owned.
 Liabilities: What owed.
 What do you own? Cash, textbooks, car, etc.
What do you owe? Credit card loan, student
loan, utility bill?

4. Bank Balance Sheet
 Like any other organizations, bank’s balance sheet list
all of its assets and liabilities and their (book) values.
 Some asset and liability items are same as other
organizations such as fixed assets (e.g. buildings and
equipments) and note payables (e.g. bonds issued by
banks).
 Banks have very different items on their note
receivables (on their assets side) and account
payables (on their liabilities side), which business
students, in particular accounting majors, should not
confuse!

5. Bank Assets
 Bank assets are what a bank owns or its claims for
future payments.
 Cash in vault
 Deposits at the Federal Reserve Bank
 Securities (e.g. Treasury bonds, municipal bonds)
 Loans (e.g. Consumer loans, mortgage loans, student
loans, commercial loans)
– These items are considered liabilities for businesses and
households who get loans from banks, but assets (note
receivable) for banks which make loans.
 Fixed assets (e.g. Buildings, ATM machines)

6. Bank Liabilities and Owners’ Equity
 Bank liabilities are what a bank owes.
 Deposits (e.g. checkable deposits, non-transaction
deposits – CDs)
– These are considered as assets for households and
businesses who deposit funds at banks, but liabilities
(account payable) for banks which borrows funds (called
deposits) from them.
 Borrowings include
– Loans from other banks: Federal funds
– Loans from the Fed: Discount loans
– Long-term bonds that a bank issued
 Bank’s owners’ equity is called “capital” or “net worth”
– Owners’ equity is the difference between total assets and total
liabilities.

7. Federal Reserve Bank as Bank for Banks
 The Federal Reserve not only serves as the monetary
authority in the U.S. to conduct the monetary policy,
but also functions as the bank for all banks in the U.S.
 Like any bank, the Fed accepts deposits from banks.
– The Fed uses banks’ accounts to make settlements among
them (like checking accounts).
 Like any bank, the Fed provides loans (discount
loans) to banks.
– The Fed charges an interest on its discount loans (discount
rate)

8. Settlements at the Fed
 Ron purchases Xbox 360 at Wal-Mart and pays by a check, where Wal-Mart has its
account at Wachovia Bank and Ron has his account at Bank of America.
 Wal-Mart deposits Ron’s check at Wachovia Bank, which sends it to the Fed. The
Fed debits Bank-of-America account and credits Wachovia-Bank account by $299.
 Wachovia Bank credits Wal-Mart account by $299, while Bank of America debits
Ron’s account by $299.
 The Fed uses Wachovia-Bank and Bank-of-America accounts at the Fed to settle
rather than shipping cash from Bank-of-America to Wachovia Bank.
Wal-Mart Ron
$299
Check
Wachovia
Bank
Bank of
America
Fed

9. Reserves
 Sum of Vault cash and deposits at the Fed is called
“Reserves.”
 Reserves are important for banks, since they are
extremely liquid and are used to pay back to depositors
whenever they withdraw funds.
 Required Reserves: The Fed requires banks to keep a
certain fraction (required reserve ratio) of deposits at
banks.
 Excess Reserves: Any extra reserves held by a bank
beyond the required reserves.
 The original idea of reserves is to ensure each bank to
hold enough cash to meet depositors’ withdrawals, but
now required reserves are used to control the money
supply (for conduct of monetary policy).
 The Fed pays interest on required and excess reserves.

10. Required Reserves: Example
 Bank of America has $100 million of deposits
and holds $15 million of reserves. A required
reserve ratio is 10%.
 Required reserves are 10% of $100 million
deposits, that is $10 million.
 Excess reserves are any reserves held by
Bank of America over its required reserves,
that is $5 million (= $15 million - $10 million).

11. Bank Balance Sheet in U.S.
As of June 2011

12. Simplified Bank Balance Sheet
 The balance sheet in the previous slide lists
major assets and liabilities items that a typical
commercial bank in the U.S. holds.
 However, for simplicity of analysis, we only
focus on the following items in this course.
Reserves
Securities
Loans
Deposits
Borrowings
Capital
Assets Liabilities &Owners’ Equity

13. Banking Operations
 What does a bank do? It does not produce or
sell anything.
 Remember the chart of “Financial System” in
Learning Unit 2? Banks simply borrow funds
from someone who have excess funds and
lend the funds to someone else who are short
in funds. So, we call them “Financial
intermediaries.”
 We use T-accounts to see how a bank
operates its basic banking business: first
borrow, then lend.

14. T-account
 T-account shows a change in items on the
balance sheet.
– Changes in asset items are shown on the left side,
while changes in liability items are shown on the
right side.
– An increase in item is indicated as “+” sign, while a
decrease in item is indicated as “-” sign.
 Important! T-account system used in this
course is different from T-account used in
Accounting. Don’t be confused.

15. Basic Bank Operation: Deposit
 Example: Tiffany deposits $100 cash at Bank of
America.
 This transaction affects the balance sheet of
Bank of America.
– Bank of America has $100 additional cash in its vault.
 Its reserves increase by $100.
– Bank of America owes $100 to Tiffany.
 Its deposits increase by $100.

16. Deposits Operation in T-Account
 This transaction can be shown in one simple T-
account.
 Since deposits are liabilities item, it is shown as an
increase of $100 on the liabilities side.
 Since cash is a part of reserves, an additional cash is
shown as an increase of reserves by $100 on the
assets side.
 Both assets and liabilities increase by $100, so the
bank’s balance sheet still balances!
Reserves +$100 Deposits +100
BankAmerica

17. Changes in Deposits and Reserves
 When a bank receives deposits, it gains an
equal amount of reserves.
 When it loses deposits (depositors withdraw
funds), it loses an equal amount of reserves.
 If Tiffany withdraws $100 from Bank of
America,
Reserves -$100 Deposits -100
BankAmerica

18. Basic of Bank Operation: Required
Reserves
 A required reserve ratio is 10%.
 With $100 deposit by Tiffany, Bank of America
must maintain additional required reserves of
$10 (= $100 of additional deposits x 10%
required reserve ratio).
 This will leave additional $90 excess reserves
(= $100 additional reserves - $10 additional
required reserves).
 What will Bank of America do with this extra
funds? Of course, loan it out!

19. Basic of Bank Operation: Loan
 Eric wants to borrow $90 from bank of America to
purchase a textbook.
 Eric fills his loan application, signs it, and receives $90
cash from a loan officer at Bank of America.
– Bank of America has $90 less cash.
 Its reserves decrease by $90.
– Eric promises to pay back $90 later, so Bank of
America has additional $90 loan contract (note
payable).
 Its loans increase by $90.

20. Loan Operation in T-Account
 Since both reserves and loans are assets items, their
changes are shown on the left side of T-account.
 Net change in assets items is $0 (= -$90 of reserves +
$90 of loans), while there is no change in liabilities.
 Since both sides of T-account do not change in net,
the bank’s balance sheet still balances!
Reserves -$90
Loans +$90
BankAmerica

21. Consolidate Bank Operations
 In the previous slides, you see two basic operations of
bank’s business: deposit and loan. Here, two
transactions are combined to see overall effects of the
basic banking operations on bank’s balance sheet by
combining two T-accounts.
 On the first transaction, both deposits (on liabilities
side) and reserves (on assets side) increase by $100.
 On the second transaction, reserves (on assets side)
decrease by $90 and loans (on assets side) increase
by $90.
 Changes in reserves in two transactions partly offset
each others, leaving an increase of reserves by $10.

22. Consolidate T-Account
 The consolidated T-account shows
– Bank of America received $100 funds in form of
deposits, then
– Bank of America keeps $10 reserves as required
and uses $90 to make a loan.
Reserves +$10
Loans +$90
BankAmerica
Deposits +$100

23. Sources and Uses of Funds
 Bank balance sheet shows where a bank gets
funds and where the bank uses that funds for
its banking business.
 Sources of funds: items on the liabilities side
show where a bank gets funds for its business.
– Deposits, Borrowings (funds borrowed from other
banks or the Fed), or Capital (funds contributed by
shareholders)
 Uses of funds: items on the assets side show
where a bank uses funds for its business.
– Reserves, loans (lend out to borrowers), securities
(purchased for investment)

24. Costs and Revenues of Bank
 Bank balance sheet also shows where a bank
earns revenues and where the bank incurs
costs for its banking business.
 Sources of funds incur costs of banking
business:
– Interest paid on deposits to depositors and on loans
borrowed from other banks or the Fed
 Uses of funds provide revenues of banking
business:
– Interest earned on loans from borrowers and on
securities

25. Interest Rates, Revenue, and Cost
 Example: Bank of America pays 3% interest
rate on deposits and charges 20% interest rate
on loans on two transactions earlier.
 Revenues = $90 x 20% = $18
– Note: Reserves do not earn any interest revenue.
 Costs = $100 x 3% = $3
Reserves +$10
Loans +$90
BankAmerica
Deposits +$100

26. Profits of Banking Business
 With 3% interest rate on deposits and 20% interest
rate on loans, Bank of America will earn $15 gross
profits on these transactions.
– Gross Profits = Revenues – Costs = $18 - $3
 This profit does not include any costs of labor (teller
salary) or capital (office equipments, office building),
so net profit will be much smaller.
 If Bank of America pays 20% interest rate on deposits,
what will happen to its profits?
– Should a for-profit business firm like Bank of America give
high or low interest rates on deposits? How about high or low
interest rates on loans?

27. How Bank Make Profits
 Banks charge high interest rates on loans and give low interest
rates on deposits to make profits.
 This difference in interest rates is considered as fee charged on
services that the bank provides to its customers.

28. Interest Rates and Banking Services
 Remember what affect an interest rate on an asset?
Risk, liquidity, and maturity [See Learning unit 12 &13].
 Banks can charge high interest rates on loans because
loans are usually
– Risky, illiquid, and long-term
 Banks can pay low interest rates on deposits because
deposits are usually
– Safe, liquid, and short-term (on demand)

29. Asset Transformation as Banking Service
 Banking business involves asset transformation: They
issue short-term liquid and safe financial instruments
(deposits) to depositors and acquire long-term illiquid and
risky financial instruments.
 For savers, banks as financial intermediaries transform
long-term illiquid risky loans issued by borrowers to short-
term liquid safe deposits.
– In addition, banks provide information services (remember three
financial services?) that they find best borrowers for depositors’
funds.
– Depositors accept low interest rates on their deposits in order to
receive these services. If not, they can lend their funds directly to
any borrowers and charge 20% interest rate? Will you?

30. Off-Balance-Sheet Activities
 Bank’s balance sheet shows how a bank generate
revenues, incurs costs, and earns profits.
 There are some banking activities which are not visible
on its balance sheet, but affect bank’s profits.
 Off-balance-sheet activities: Bank activities that affect
bank profits but are not visible on bank balance sheet.
– Loan sales
– Fee income
– Trading activities and risk management techniques

31. Loan Sales
 Traditionally, when a bank makes loans, most likely
the bank keeps them until their maturities.
 Recently, many banks sell loans to the third party and
earn instant profits (rather than waiting for their
maturities to realize profits).
– Securitization [Learning unit #6]
– Banks still collect payments from borrowers (or contract out
this activities to “servicer” firm), but simply send them to the
third party which owns those loans.
 Profits (or losses) on loan sales are not visible from
bank’s balance sheet.
– In early 2000s many banks made significant profits from sub-
prime mortgage loan sales.
– Loan sales also allow banks to pass any risk associated with
loans to the third party.

32. Fee Incomes
 Banks charge on many banking and related services.
– Bounced check fee
– Minimum balance fee or account maintenance fee
– Late payment fee
– ATM user fee
– Safe deposit fee
– Notarization fee
– Loan origination or processing fee
– Annual membership fee (on credit cards)
– In 2005, Bank of America even tried to charge fees to
customers who use a teller rather than ATM machine.

33. Trading Activities & Risk Management
 Banks engage in derivative trading for
hedging.
– On the balance sheet, derivatives are not seen as
large as actual obligations, since only a fraction of
actual obligations is usually shown on its balance
sheet.
– Derivatives can bring more profits to banks by
engaging in speculation as well as potentially huge
losses if they are not used properly.

34. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University