A good way to
understand how banks work is to imagine starting your
own bank. The first thing you need to do is put up some of your
money. You won’t receive a banking license unless you have your
capital at risk.
Let’s assume you raise $6 million in cash with help from
That will be the bank’s initial equity, the owner’s stake. Next
obtain a charter, rent a building, furnish it with all the necessary
hire and train a staff, and open your doors for business.
You’ll need to deposit some of your initial stake at the
Those funds will be used to clear checks written by your own
You’ll also need to keep enough cash in the vault to meet the demand
withdrawals by your depositors. Let's assume initial expenses of
$1.2 million. That leaves $4.8 million, of which you allocate $2
million to vault cash and $2.8 million to your Fed account.
Managing Loans and Other
As your business develops, some customers will deposit
their own money
to open checking accounts. Others will invest in your savings
and certificates of deposit (term loans) which must pay a competitive
rate. Still others will seek loans from the bank. It is up
to you to determine whether prospective borrowers are good credit
and will be able to pay the interest charges and return the principal
the specified date.
In managing your bank, you will need an accounting
system to determine
how your decisions are likely to affect the bank’s profitability.
The most important account is the balance sheet. This shows at
given moment, the bank’s assets (what it owns), its liabilities (what
owes to others), and its net worth (what belongs to the owners).
Net worth, or equity, is equal to assets minus liabilities. Your
equity should remain positive and preferably growing. If it ever
gets too low relative to total assets, your regulator may close the
Balance Sheet and Earnings
If your bank does well, the balance sheet will expand
with new assets
and liabilities. The equity should also increase, assuming you
some of the profits in the bank rather than pay them all out as
to the owners. You started with initial equity of $6
Let’s take a look at the balance sheet after you have been in business
for some time. It is shown together with an earnings forecast for
the coming year.
The earnings forecast is based on expected earning rates
of the bank’s
assets and the cost of borrowed funds. Also shown is the expected
cost of operations or fixed costs, covering rent, insurance, utilities,
salaries, etc. The entries in blue are items that you might try
modify to see how they would affect the key performance measure, the
on equity. Of course, you must maintain the required minimum
set by the regulators.
Note that your equity has grown from $6.0 million to
$10.5 million due
to retained earnings. You have acquired a substantial amount in
some of which are ordinary checking accounts that pay no
Others were borrowed at market rates. All deposits whether or not
they bear interest have associated costs.
With the additional funds available from deposits, you
your assets to what you hope will enhance future earnings: $5.0
in reserves, $7.7 million in T-bills, $1.1 million in loans to other
and $110 million in ordinary loans. You project net earnings for
the coming year after taxes of $1.51 million. That would be a
on equity of 14.38% and a return on assets of 1.21%, which is quite
Required Operating Ratios
In the lower left corner of the table are the three
ratios that must
be kept above minimum values established by bank regulators. The
capital ratio is the ratio of a bank’s equity to a risk-weighted sum of
the bank's assets. The weightings are 0 for reserves, 0 for
securities, 0.2 for loans to banks, and 1.0 for ordinary loans. A
minimum capital ratio of 8% is required.
The leverage ratio is the ratio of a bank's equity to
sum of its total assets. The required minimum is 3%. The
ratio is the ratio of a bank's reserves (deposits at the Fed plus vault
cash) to its demand deposits, i.e. checking deposits. The
minimum is 10% for large banks, but only 3% on the first $45.4 million
of demand deposits, which is the case for your small bank.
How Transactions Affect
When a bank issues an ordinary loan, its assets (A)
and liabilities (L) increase
equally, while its reserves (R) remain unchanged. The reserve ratio (R/L) decreases due to the increase in L. Capital (C = A - L) remains
unchanged, and the capital ratio (C/A) decreases due to the increase in A. When computing the capital ratio, we use the risk-weighted value of A in the denominator. In this case, the increase in A is all due to an increase in ordinary loans which have a risk weighting of 1.0.
When the borrower spends the funds, if they are deposited in another bank, R and L decrease by the same amount. Since R is typically a small fraction of L, R/L decreases. Risk-weighted assets remain unchanged because the only component of A that changes is R which has a risk-weighting of 0. Therefore C/A remains unchanged. If the spent funds are deposited in the bank making the loan, R, L, and A remain unchanged. so there is no change in R/L and C/A.
When the borrower pays interest on the loan out of a
the bank, L decreases while A
and R remain unchanged. This
in an increase in R/L due to the decrease in L, and an increase in C/A due to the increase in C.
the borrower pays interest from an outside source, A
and R increase while L
remains unchanged. This results in an increase in R/L due to the increase in R, and an increase in C/A due to the increase in C since risk-weighted assets remain unchanged.
When the borrower repays the loan from a deposit within
the bank, R
remains unchanged while A and L
decrease equally. R/L increases due to the decrease in L, and C/A remains unchanged. If the borrower repays the loan from an external source, R increases and L remains unchanged causing an increase in R/L. Total assets remain unchanged because the decrease in loan assets is offset by the increase in R. However the decrease in loan assets
decreases risk-weighted assets and therefore increases the C/A.
When a bank pays for its operating expenses, it may
issue a bank draft. If the recipient deposits the
in the same bank, he receives a deposit which increases L,
while A and R
remain unchanged. If he deposits it in another bank, A
unchanged. In both cases, the capital ratio and reserve ratio of
the issuing bank decrease.
While there is much more to learn about banks, this
outlines the essential details for small banks. However large
are far more complex institutions. For some of them,
is a minor part of the business. The next article surveys the
activities of large banks.