Banking, Balance Sheets, and Financial System Fundamentals

Origins of Banking

Historical Development of Banking

The modern banking system evolved from the need to securely store valuable commodities, such as gold, and to facilitate trade. Early banking practices laid the foundation for today's financial institutions.

• Commodity Money: In early economies, gold was used as money, but storing it was risky and costly.

• Goldsmiths as Bankers: Wealthy individuals entrusted their gold to goldsmiths, who had secure storage facilities.

• Paper Money: Goldsmiths issued receipts for deposited gold. These receipts, made payable to the 'Bearer,' began to circulate as a form of money, being lighter and safer than gold itself.

• Warehouse Receipts: The origin of paper money can be traced to these gold deposit receipts, which functioned as claims on physical gold.

Example: A merchant deposits gold with a goldsmith and receives a bearer receipt, which he then uses to pay for goods. The receipt changes hands, functioning as money.

From Safekeeping to Lending

The Emergence of Fractional Reserve Banking

As goldsmiths noticed that not all depositors withdrew their gold at once, they began lending out a portion of the deposits, keeping only a fraction as reserves. This practice is the basis of modern banking.

• Idle Gold: Most deposited gold remained unused in vaults.

• Lending Opportunity: Goldsmiths lent out some of the gold, earning interest, while maintaining enough reserves for daily withdrawals.

• Fractional Reserves: Only a fraction of deposits are kept as reserves; the rest are lent out, creating the foundation for money creation in the banking system.

Additional info: This system allows banks to expand the money supply through lending, a key concept in macroeconomics.

The Bank Balance Sheet

Structure and Core Identity

A bank's balance sheet provides a snapshot of its financial position, listing assets (uses of funds) and liabilities (sources of funds). The balance sheet must always balance: total assets equal total liabilities plus bank capital (equity).

• Assets: What the bank owns or is owed (e.g., reserves, loans, securities).

• Liabilities: What the bank owes to others (e.g., deposits, borrowings).

• Bank Capital (Equity): The difference between assets and liabilities; represents owners' stake.

Equation:

$\text{Assets} = \text{Liabilities} + \text{Bank Capital}$

Modern Bank Liabilities (Sources of Funds)

Types of Liabilities

Banks obtain funds from various sources, each with different characteristics and implications for risk and regulation.

• Deposits: The primary source, including checking and savings accounts from the public.

• Borrowings:

  • Interbank Loans: Short-term loans from other banks (e.g., Federal Funds in the US), with the interest rate known as the Fed Funds Rate.

  • Central Bank Loans: Emergency loans from the central bank (e.g., Discount Loans in the US), with the Discount Rate as the interest rate.

• Bank Capital (Equity): Funds provided by shareholders, serving as a financial cushion against losses.

Modern Bank Assets (Uses of Funds)

Types of Assets

Banks allocate their funds among various asset classes, each with different liquidity and risk profiles.

• Reserves: Cash held in the vault or at the central bank to meet withdrawal demands.

• Loans: Direct lending to individuals and businesses (e.g., mortgages, commercial loans). These are generally illiquid but profitable.

• Securities: Marketable financial instruments, such as government bonds, corporate bonds, shares, and mortgage-backed securities (MBS), which can be sold in secondary markets.

Loans vs. Securities

Key Differences and Mechanics

Loans and securities are both assets for banks, but they differ in terms of liquidity, tradability, and risk.

• Loans: Non-tradable, bilateral agreements where the bank lends principal (P) and receives repayment (F) in the future.

• Securities (Bonds): Tradable debt contracts with a fixed future payment (F). The market determines the price (P) at which the bond is sold.

Interest Rate Formula for Loans:

$r = \frac{F}{P} - 1$

Where:

• r: Interest rate

• F: Future value (repayment)

• P: Principal (amount lent)

Bond Price Formula:

$P = \frac{F}{1 + r}$

Inverse Price-Yield Relationship: As interest rates (r) rise, bond prices (P) fall, and vice versa.

Equity Shares and Valuation

Nature and Pricing of Shares

Shares represent ownership in a corporation and entitle holders to a portion of future profits. Their value is determined by market expectations of future profitability.

• Ownership: Shareholders have a claim on a company's future earnings, not a fixed payment.

• Valuation: Share prices fluctuate based on news, economic conditions, and sector-specific developments.

Example: The price of Microsoft shares may rise due to positive news about AI integration, reflecting expectations of higher future profits.

Balance Sheet Dynamics & Shocks

Impact of Market Changes on Bank Capital

Changes in asset values directly affect a bank's capital. Positive or negative shocks can expand or shrink the bank's equity.

• Positive Shock: Falling interest rates increase bond values, raising asset values and bank capital.

• Negative Shock: Rising interest rates or loan defaults decrease asset values, reducing bank capital.

The Threat of Insolvency

Definition and Consequences

Insolvency occurs when a bank's assets fall below its liabilities, resulting in negative bank capital. The bank cannot meet its obligations to depositors and lenders.

• Condition: $\text{Assets} < \text{Liabilities}$

• Consequence: The bank is considered insolvent and may be closed or taken over by regulators.

The Rationale for Bank Regulation

Purpose and Types of Regulation

Bank regulation exists to protect public savings and maintain financial stability. Several regulatory measures are in place to reduce the risk of bank failures.

• Capital Adequacy Requirements: Banks must maintain a minimum level of capital to absorb losses.

• Reserve Requirements: Banks are required to hold a certain ratio of liquid reserves to deposits.

• Deposit Insurance (e.g., FDIC): Government guarantees of deposits to prevent bank runs.

• Asset Restrictions: Limits on the types of assets banks can hold to reduce risk (e.g., restrictions on holding shares).

Bank Balance Sheet Examples

Sample Bank Balance Sheets

The following tables illustrate typical bank balance sheets, showing the relationship between assets, liabilities, and bank capital.

Assets	Liabilities
Reserves: 20	Deposits: 100
Loans: 40	Borrowing: 20
Securities: 60	Bank Capital: 10
Total: 130	Total: 130

Assets	Liabilities
Reserves: 20	Deposits: 70
Loans: 40	Borrowing: 20
Securities: 60	Bank Capital: 10
Total: 130	Total: 130

Purpose: These tables demonstrate how assets and liabilities must always balance, and how changes in deposits or asset values affect the bank's financial position.