The balance sheet of a bank
The balance sheet of a bank is comprised of, on the one side, equity and liabilities, and on the other, assets, and:
Equity and liabilities = assets.
Liabilities are made up of deposits (overwhelmingly) and short-term loans (loans from the central bank, and repurchase agreements). Thus, the essence of banking is straightforward. The banks finance themselves with own capital and reserves (equity), deposits and short-term loans, and they provide loans (NMD and MD). They also provide other services, such as indemnities, guarantees and broking services that are off-balance sheet.
The banks' income derives from interest earnings on their loans (NMD and MD), the fees charged for services, as well as opportunistic profits from financial market dealing. Their costs are comprised of interest payments on deposits and short-term loans, and the costs associated with running the bank.
We repeat a previous illustration which shows the unique position of banks in the financial system: Figure 8. It will be seen that banks also buy shares; however, this is a minuscule part of the business and holdings are usually associated with opportunistic positions / dealing in shares.
Figure 8: banks in the financial system
The purpose of this section is to provide a brief introduction to the business of banking, with a sub-purpose of attempting to build a framework for this unique industry. The details are then presented in later texts.
The broad carcass of banking maybe seen in basic terms as in Figure 9.
Figure 9: the basic business of banking
Each of these areas of banking is presented in summary form below (keep in mind that the purpose of this section is to create a broad outline the private banking sector).
Share capital (equity)
The share capital and unimpaired reserves (= equity) required to be held by a bank is the principal prudential requirement of banking legislation, and it is ultimately applied to protect the bank's deposit clients as well as the banking system from failure (systemic failure). The other prudential requirements are the cash reserve, liquid asset and large exposure requirements. The capital and reserves of the banks amount to around 8-10% of total capital and liabilities / assets.
Apart from equity, the other sources of funds of banks are:
- Loans from the central bank.
- Interbank loans.
- Repurchase agreements (repos).
Deposits are the primary source of the funding for a bank; there are two broad categories:
• Non-negotiable certificates of deposit (NNCDs).
• Negotiable certificates of deposit (NCDs).
The proportions of the two categories vary from country to country, but the former is usually the higher one, because most deposits are small. The NNCD category includes many types: call money accounts, cash managed accounts, transmission accounts, cheque accounts, savings accounts, fixed deposit accounts, notice of withdrawal accounts (NOW accounts in the US), and so on.
The term of deposits ranges from a day to a number of years, although the overwhelming term is short.
As indicated in Figure 8, deposits are taken from all the other financial intermediaries, as well as the four sectors of the economy: household, corporate, government and foreign. Deposits are denominated in LCC, and banks also offer foreign currency-denominated accounts to certain depositors.
Loans are short-term in nature and there are three categories: loans from the central bank, interbank loans and repurchase agreements (repos).
Loans from the central bank are related to monetary policy and are provided at the central bank's key interest rate (KIR - called by many names such as base rate, bank rate, repo rate, discount rate).
Interbank loans are loans from banks to banks and are provided at the interbank rate. As we will see later, there are actually three interbank markets, but this one, the bank-to-bank interbank market (b2b IBM), is the only one where a price is discovered (which is closely related to the KIR).
A repurchase agreement (repo) is a legal agreement in terms of which a security, or a parcel of securities, is sold for a portion of the life of the securities. For example, a bank may wish to take a short-term position (for 30 days) in 5-year government bonds (because it expects bond rates to fall in the 30-day period). At the same time the bank may have a wholesale deposit client needing an investment for 30 days at a rate that is higher than the deposit rate for 30 days. The bank buys the bonds outright (with the purpose of selling them outright after 30 days) and would then sell them to the client under repurchase agreement (repo), i.e. under an agreement to repurchase the same securities 30 days after the deal is struck.
It will be evident that if a bank sells a security, it leaves the balance sheet of the bank. In reality it does (the security is in fact delivered to the client), but for purposes of the prudential requirements, banks are required to show the security as an asset and the funds advanced to the bank as a loan (received under repurchase agreement).
The repo is the preferred instrument for some central banks in the conduct of monetary policy (for legal reasons). Most central banks (except in exceptional circumstances) bring about a liquidity shortage (LS) and accommodate the banking system by means of outright overnight loans (see above) or by loans via purchasing repos from the banks for specified short-term periods. The rate charged by the central bank for this accommodation is usually called the repo rate (as noted, it is another name for the KIR).
Figure 10 is presented as a summary of the sources of funding of banks.
Figure 10: the business of banking: liabilities