Brief Notes on Mishkin Chapter 10
("Banking and the Management
of Financial Institutions")
Econ 353: Money, Banking, and Financial Institutions

Last Updated: 28 March 2015
Latest Course Offering: Spring 2011

Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT iastate.edu
Econ 353 Home Page:
http://www2.econ.iastate.edu/classes/econ353/tesfatsion/

  1. The Bank Balance Sheet
  2. Bank Management and Information Problems
  3. Basic Concepts and Key Issues from Mishkin Chapter 9

The Bank Balance Sheet

The balance sheet of a bank is a listing of its assets (what it owns), its liabilities (what it owes to others), and its net worth, defined to be the difference between its assets and its liabilities. It follows that, as a matter of accounting identity:


(1)        Assets    =    Liabilities    +    Net Worth

Note: Other expressions used to refer to the net worth of a bank include Bank capital, bank equity, or simply equity. Mishkin uses all three.

Bank liabilities are a bank's sources of funds. These liabilities generally take three basic forms:

Bank assets indicate the way in which a bank is using its funds. Bank assets generally take the following forms:

The T-Account for a bank is a simplified balance sheet that lists only the changes that occur in balance sheet items starting from some initial balance sheet position.

Bank Management and Information Problems

As discussed in Chapter 8, banks facilitate the channeling of funds between savers and investors by reducing transactions and information costs.

However, by collecting deposits from savers to channel to investors, the bank becomes a borrower of these deposited funds from savers and a lender of these funds to investors. The original asymmetric information problem between savers and investors is thus essentially divided into two different asymmetric information problems: between savers and the bank; and between the bank and the investors.

That is, just as the bank now has to worry about adverse selection and moral hazard problems arising with its investor-borrowers, so also the depositors have to worry about adverse selection and moral hazard problems arising with their borrower, the bank.

In particular, regarding adverse selection, depositors may have an idea about the financial condition of the banking system in general, but they may not know the financial condition and operating characteristics of any single bank. Banks compete against each other for depositors by offering competitive interest rates on deposit accounts. The information problem for savers is that a bank may be financing high interest rates on its deposit accounts in several different ways.

For example, the bank may be efficient in its lending operations, so that the bank manages to earn a healthy profit even though the bank's borrowers are charged only moderately higher interest rates than are being paid on deposits. Or the bank may be engaging in high-risk lending and charging very high interest rates to its high-risk borrowers.

Regarding moral hazard, it may be difficult for depositors to monitor the activities of bank managers to ensure that the bank managers are engaging in sound management practices needed to keep the bank in healthy financial condition.

For example, are managers maintaining enough cash on hand to meet deposit withdrawal demands (liquidity management)? Are they pursuing an acceptably low level of risk by acquiring assets that have a low rate of default and that are well diversified (asset management)?

Are bank managers acquiring funds at a reasonably low cost (liability management)? Are managers maintaining an appropriate level of net worth to provide a security cushion in the face of unexpected decreases in the value of the bank's assets and to meet net worth (bank capital) requirements as set by regulatory authorities (capital adequacy management)?

Are managers protecting the bank against the credit risk arising because borrowers may default, or the interest rate risk arising because interest rates may vary unexpectedly, causing volatility in bank profits if the bank holds interest-sensitive assets (e.g., variable rate loans) and/or interest-sensitive liabilities (e.g., money market deposit accounts)?

Also, in recent years, off-balance-sheet activities have been growing in importance for banks. These are activities that affect bank profits but do not appear on bank balance sheets, and so are particularly hard for depositors and other outsiders to monitor. Examples include the generation of income from the provision of specialized services to customers, such as making foreign exchange trades, servicing mortgage-backed securities by collecting and distributing interest and principal payments, and providing back-up lines of credit (e.g., overdraft privileges on deposit accounts).

When a bank (or any firm) engages in off-balance-sheet activities, it makes it more difficult for shareholders, ratings agencies, accountants, regulators, and other interested parties to keep track of the true financial condition of the bank. In particular, it makes it difficult to keep track of the bank's ability to meet its financial obligations.

The ability of a bank (or any firm) to meet its financial obligations is often measured by some form of leverage indicator. A wide variety of leverage indicators are in use for banks and other firms in practice, one of the simplest being the debt-to-equity ratio calculated by dividing liabilities (debts) by net worth (equity).

As explained by Charles Jones ("The Global Financial Crisis: Overview," May 22, 2009, p. 20), leverage (as measured by a debt-to-equity ratio) is an important financial indicator because it magnifies both gains and losses on net worth. This is as true for private individuals as it is for banks and other financial firms.

For example, suppose you have purchased a home for $100,000 with a 10% down payment and with the remaining 90% financed by a loan. Then your assets from this purchase are $100,000, your debts from this purchase are $90,000, and your net worth (equity) in this home is $10,000. It follows that your leverage (as measured by a debt-to-equity ratio) is 9 = $90,000/$10,000. If the price of the home now drops by 5%, to $95,000, then your assets drop by $5,000 and your loss on equity is 50% = 100% x [$5,000/$10,000]. That is, a 5% drop in your home price results in a 50% loss on equity in this home.

Basic Concepts and Key Issues from Mishkin Chapter 10

Basic Concepts:

Key Issues:

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