Accounting for Financial Services-JAIBB

BANKING DIPLOMA EXAMINATION

Banking Diploma Courses in Bangladesh under The Institute of Bankers, Bangladesh (IBB)

   Accounting for Financial Services- JAIBB

Accounting for Money and Banking

In these notes we will find the following topics:
 
I.     Bank balance sheets 
II.   T-accounts
III.  Areas of bank management  

I. BANK BALANCE SHEETS

Balance sheets are the standard accounting tool for listing a bank's assets and liabilities, which is all that a bank's balance sheet is.  Drawing one up is fairly simple:
-- Step one:  Draw a big lower-case "t." 
-- Assets (how the bank uses its funds) go on the left side.
-- Liabilities (sources of funds, or how the bank gets its funds) go on the right side.
 You may have seen a similar table in introductory macro.  The numbers in parentheses are the proportions of the total.

ASSETS	LIABILITIES + BANK CAPITAL
Reserves (cash on hand or stored with Fed) (1%)	DEPOSITS (checking 5% + savings & CDs 56% = 61%)
Cash items in the process of collection (2%)	Borrowings (loans from other banks and nonbanks) (21%)
Securities (government and other bonds, mortgage-backed securities) (23%)	Other liabilities (including borrowings from foreign sources) (8%)
LOANS to firms, individuals, etc. (65%)
Other assets (9%)	Bank capital ( = Total assets - Total liabilities) (10%)
--------------------------------------------------------	--------------------------------------------------------
TOTAL ASSETS (100%; $11.2 trillion in March 2008)	TOTAL LIABILITIES + BANK CAPITAL (100%; $11.2 T)

For the balance sheet to "balance," the two sides must add up to the same amount.  However, a healthy bank will not have equal amounts of assets and liabilities, but will instead have more assets than liabilities.

                              Assets - Liabilities = Bank capital (or Net worth)

What we do to make the two sides equal is to add Bank capital to the Liabilities side.  (Note that it now bears the heading "Liabilities + Bank Capital."  Bank capital could be either equity (shares of stock in the bank) or retained earnings.

We normally list the most liquid items first.  (The general rule is to list items in descending order of liquidity.)

On the asset side, then, the first item on a bank's balance sheet is reserves, which banks keep to meet deposit outflows (withdrawals, checks drawn on the bank, etc.) and because they're required to do so by the Fed.

-- Banks are required by the Fed to hold a certain proportion of their deposits as reserves, mainly to guard against "runs on the bank" and to allow the Fed to manipulate the money supply. Reserves can be held either as cash or in accounts at the Fed.  Currently, the required reserve ratio (RRR) is 10% on checking accounts and zero on savings and money-market accounts.

The difference between a bank's total reserves and its required reserves is its excess reserves:
excess reserves (ER) = actual reserves - required reserves
                                     = actual reserves - (.10)(checking deposits)

Excess reserves are mainly kept by banks as a precaution. In good times, banks generally try to keep as few excess reserves as possible, since they earn no interest on them. The Fed's reserve requirements are typically much higher than what banks actually need in order to be able to handle deposit outflows. 

II. T-ACCOUNTS

... are a modified form of balance sheets, useful for examining how a bank reacts to changes. Instead of laboriously listing all of the bank's assets and liabilities, T-accounts list only the changes in the bank's assets and liabilities.

For example, suppose I won the NCAA basketball pool and get paid with a check for $100, drawn on Prof. Spizman's account at the Key Bank, and deposit it into my checking account at Pathfinder Bank.  The initial change, before the check clears, to my bank's balance sheet will be as follows:

Pathfinder Bank, BEFORE Check Clears
 

ASSETS (A)	LIABILITIES (L)
Cash items in the process of collection + $100	Checking deposits + $100

At Key Bank, before the check clears there is no change on Key's balance sheet, because Key has no way of knowing that someone has written a check on a Key account. They don't find out about that until the check has gone to the New York Fed to be cleared.

After the check clears, the change in Pathfinder Bank's balance sheet is just a bit different, and Key's balance sheet will be a lot different:

Pathfinder Bank, AFTER Check Clears
 

ASSETS (A)	LIABILITIES (L)
Reserves at Fed + $100	Checking deposits + $100

 If the reserve requirement is 10%, the bank has an increase in excess reserves of --?
      (Change in) excess reserves = total reserves - required reserves
                                                 = $100 - (10%)($100)
                                                 = $100 - $10 = $90

It will probably loan out those excess reserves, so as to earn interest on them.

Key Bank, AFTER check clears
 

ASSETS (A)	LIABILITIES (L)
Reserves at Fed  - $100	Checking deposits   - $100

The change in Key's excess reserves is negative, since only $10 had to be held as reserves against those $100 in checking deposits yet $100 cash is now gone. So if the bank had zero excess reserves before, it would now have excess reserves of -$90 (= -$100 -(-$10)), or a reserve deficiency of $90. To obtain that $90, the bank would have to borrow some funds from the Fed or another bank, borrow from a corporation (repo), sell off some of its assets (e.g., T-bills), issue commercial paper, or call in some of its loans. Of those options, calling in some of its loans (usually accomplished by simply not renewing short-term loans) is the one the bank likes least, because its loans are its most profitable business -- a bank, after all, makes a profit by obtaining funds at a relatively low interest rate (zero on basic checking accounts) and loaning them out at much higher interest rates . Also, the customer whose loan is called in will have to take his business elsewhere, and might do so permanently; since banks hate to lose good customers, they generally avoid calling in loans early.

III. AREAS OF BANK MANAGEMENT

Going down a typical balance sheet, we can note four different areas of primary concern to a profit-maximizing, risk-averse bank management team. A bank's managers have to keep track of four different primary areas:

(1) LIQUIDITY MANAGEMENT: make sure the bank has just enough cash reserves and liquid assets to meet (net) deposit outflows and its reserve requirements at the Fed.
-- Here we see the usual risk-return relationship.  Reserves don't pay interest, so keeping too much in the way of reserves reduces the bank's overall profitability.  But holding just the bare minimum of reserves exposes the bank to liquidity risk, i.e., the risk of failing to meet its Fed reserve requirements or being unable to meet an unexpectedly large deposit outflow.

(2) ASSET MANAGEMENT: acquire assets (loans, securities) with acceptably low risk and high return.
-- Several types of risk come into play here. 
---- First, there is credit risk, or default risk -- the possibility that some of the loans owed to the bank won't be repaid, or that some of its bonds and other securities might default.
---- Bank loans and bond holdings are also subject to interest-rate risk -- the possibility that market interest rates might go up, causing the bank's fixed-rate loans to lose value.
------ Because interest-rate risk is particularly severe on household mortgages, which typically have a length of 30 years, banks tend to sell their mortgages off as quickly as possible, to government agencies like the Federal National Mortgage Association (which buy them up and repackage them as securities to sell to the public).
---- (In addition, especially for banks that are active in financial derivatives markets, there is trading risk, or market risk, if, say, a derivatives contract ends up obliging the bank to sell a financial instrument for less than it paid for it.)
-- As with household investors, banks can reduce some of their risk through diversification, e.g., by making different kinds of loans and holding securities of varying maturity lengths.

(3) LIABILITY MANAGEMENT: acquire funds (deposits, borrowings) at low cost
-- A good combined yardstick of asset and liability management together is the bank's interest-rate spread: the difference between the average interest rate at which the bank loans (earns) money and the interest rate at which the bank borrows (pays) money.
-- Interest-rate risk comes into play here as well.  Higher interest rates can deal a bank a double-blow -- the PDV of the bank's long-term fixed-rate loans and bonds takes a beating, while the bank has to pay higher interest rates to its depositors in order to be competitive.

(4) CAPITAL ADEQUACY MANAGEMENT: decide how much capital (net worth) the bank should have and acquire it
-- Capital adequacy management is similar to liquidity management. Just as a bank may hold excess reserves to guard against unexpected deposit outflows, it needs to have a decent cushion of funds -- specifically, a large enough excess of assets compared with its liabilities -- to protect it from an unexpected drop in the value of its assets, since virtually all of its loans carry at least some risk of default.
---- A bank with negative bank capital is insolvent.
-- Banks are required by federal authorities to meet certain minimum capital requirements. The level of bank capital can be either too high or too low: too much bank capital dilutes the shareholders' equity, thus reducing their returns (i.e., their return on equity), whereas too little puts the bank at risk of insolvency.
-- In the economic crisis of 2008-2009, bank capital is absolutely crucial, because many banks appear to be insolvent, especially those that had large quanitities of mortgage-backed securities among their assets.  Those securities have lost much of their value, so probably a good many banks that held them are now insolvent.  But virtually nobody knows the exact value of those securities, as there's not much of a market for them at present (winter 2009) -- hedge funds and various bargain hunters are willing to buy them at rock-bottom prices, but banks would rather hold onto them than sell them for so little.  So depending on how one calculates the values of those mortgage-backed securities, a particular bank might still be solvent or it might not.

A simple way to memorize the four areas of bank management: just remember the acronym "LALC"
-- for Liquidity management, Asset management, Liability management, and Capital adequacy management.

Q: A bank sells a 1-year CD for $100,000, at an interest rate of 3%.  It uses the proceeds to buy $100,000 worth of 10-year Treasury bonds paying 6%.  What would happen if all interest rates rose by 2 percentage points the next day?  (What kind of risk has the bank exposed itself to?) A: The PDV (and hence the balance-sheet value) of those long-term bonds would drop sharply if market interest rates rose by 2%.  This would lower the value of the bank's assets.  On the liabilities side, the PDV of the 1-year CD would drop, too, but not by as much, because the PDV's of short-term interest-bearing assets are less affected by interest-rate changes than are the PDV's of long-term bonds.  (In other words, long-term assets have more interest-rate risk than short-term assets.)  The value of the bank's assets would decline more than the value of the bank's liabilities, which is bad news for the bank.