Bank Accounting and Fractional Reserve

Banking (Review)
Bank Capital and Profitability
The Money Multiplier
Change in Total Deposits
Change in the Money Supply

Bank Balance Sheet

Assets (A)
Anything the bank
owns
Any amount the
bank is owed

Liabilities (L)
Deposits
Savings Deposits
Checking Deposits

Bank Capital
(= A L)

(Often called bank capital)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves
Vault Cash

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves
Vault Cash
Deposits with
the Fed

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves
Vault Cash
Deposits with
the Fed

Loans

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves
Vault Cash
Deposits with
the Fed

Loans
Bonds

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)

Liabilities (L)

Reserves
Vault Cash
Deposits with
the Fed

Loans
Bonds
Other Assets

Bank Capital
(= A L)

Bank Balance Sheet

Assets (A)
Reserves
Vault Cash
Deposits with
the Fed

Loans
Bonds
Other Assets

Liabilities (L)
Savings Deposits
Checking Deposits
Bank Capital
(= A L)

The Balance Sheet HAS TO

Balance
NW = A L
A = L + NW (or Capital)

Bank Capital and Profitability

Remember that net worth equals assets
minus liabilities.
Net worth is referred to as bank capital, or
equity capital.
We can think of capital as the owners stake
in the bank.
Capital is the cushion banks have against a
sudden drop in the value of their assets or
an unexpected withdrawal of liabilities.
It provides some insurance against insolvency.

Bank Capital and Profitability

An important component of bank capital is
loan loss reserves:
Loan loss reserves are an amount the bank sets
aside to cover potential losses from defaulted
loans.

At some point the bank gives up hope a loan

will be repaid and it is written off, or erased
from the banks balance sheet.
At this point, the loan loss reserve is
reduced by the amount of the loan that has
defaulted.

Bank Capital and Profitability

The ratio of debt to equity in the U.S. banking
system was about 8 to 1 in January 2013.
Although that is a substantial amount of
leverage, it is nearly 25% below the average
commercial bank leverage ratio that prevailed
prior to the financial crisis of 2007-2009.
Debt-to-equity ratio for nonfinancial business in the
U.S. is less than 1 to 1.
Household leverage is roughly 1/3 to 1.

Leverage increases risk AND expected return.

Bank Capital and Profitability

One of the explanations for the relatively high
degree of leverage in banking is the existence
of government guarantees like deposit
insurance.
These government guarantees allow banks to
capture the benefits of risk taking without
subjecting depositors to potential losses.

Bank Capital and Profitability

There are several measures of bank
profitability.
1. Return on assets (ROA).

ROA is the banks profit left after taxes

divided by the banks total assets.
Net profit after taxes
ROA
Total bank assets

It is a measure of how efficiently a particular

banks uses its assets.
This is less important to bank owners than the
return on their own investment.

Bank Capital and Profitability

2. The banks return to its owners is measured
by the return on equity (ROE).
This is the banks net profit after taxes divided
by the banks capital.

Net profit after taxes

ROE
Bank capital

ROA and ROE are related to leverage.

One measure of leverage is the ratio of
banks assets to bank capital.
Multiplying ROA by this ratio yields ROE.

Bank Capital and Profitability

Netprofitaftertaxes
ROE
BankCapital

ROA *

BankAssets Netprofitaftertaxes BankAssets

*
BankCapital
Totalbankassets
BankCapital

Netprofitaftertaxes

ROE
Bankcapital

Bank Capital and Profitability

Prior to the financial crisis of 2007-2009,
the typical U.S. bank has a ROA of about
1.3%.
For large banks, the ROE tends to be higher
than for small banks, suggesting greater
leverage, a riskier mix of assets, or the
existence of significant economies to scale
in banking.
The poor performance during the crisis and
moderate returns after, suggests their high
returns were at least partly due to more leverage
or a riskier mix of assets.

Bank Capital and Profitability

3. The final measure of bank profitability is net
interest income.
This is related to the fact that banks pay interest on
their liabilities and receive interest on their assets.

Deposits and bank borrowing rate interest expenses;

securities and loans generate interest income.

The difference between the two is net interest

income.

Bank Capital and Profitability

Net interest income can also be expressed
as a percentage of total assets to yield: net
interest margin.
This is the banks interest rate spread - the
weighted average difference between the
interest rate received on assets and the
interest rate paid for liabilities.

Well-run banks have a high net interest

income and a high net interest margin.
If a banks net interest margin is currently
improving, its profitability is likely to
improve in the future.

Money Multiplier: Step 1

Somebody Deposits $10,000 in
Bank of America
Assets (A)
Reserves

Liabilities (L)
Checking Deposits

Loans
Bank Capital

Money Multiplier: Step 1

Somebody Deposits $10,000 in
Bank of America
Assets (A)
Reserves +$10K

Liabilities (L)
Checking Deposits +$10K

Bank Capital

Total New Deposits

$10,000

Original Deposit

Money Multiplier: Step 1

Somebody Deposits $10,000 in
Bank of America
Assets (A)
Reserves +$10K

Liabilities (L)
Checking Deposits +$10K

- New Loans $9K

Bank Capital

Money Multiplier: Step 1

Somebody Deposits $10,000 in
Bank of America
Assets (A)
Reserves +$10K

Liabilities (L)
Checking Deposits +$10K

-New Loans $ 9K
Bank Capital
Loans +$ 9K

Money Multiplier: Step 1

Somebody Deposits $10,000 in
Bank of America
Final Changes in Balance Sheet
Assets (A)
Reserves +$1K

Loans +$9K

Liabilities (L)
Checking Deposits +$10K

Bank Capital

Money Multiplier
$9,000 loaned out by BOA ends up in
Cambridge Savings Bank
Assets (A)
Reserves +$9K

Liabilities (L)
Checking Deposits +$9K

Loans
Bank Capital

Total New Deposits

$10,000
$ 9,000

Original Deposit in BOA

Deposit in CSB

Money Multiplier: Step 2

Final Balance Sheet of Cambridge
Savings Bank
Assets (A)
Reserves +$ 900

Loans +$ 8,100

Liabilities (L)
Checking Deposits +$9K

Bank Capital

Total New Deposits

$10,000
$ 9,000
$ 8,100

Original Deposit in BOA

Deposit in CSB
Deposit in Sovereign Bank

Total New Deposits

$10,000
$ 9,000
$ 8,100
$ 7,290

Original Deposit in BOA

Deposit in CSB
Deposit in Sovereign Bank
Deposit in Citibank

Total New Deposits

$10,000
$ 9,000
$ 8,100
$ 7,290
$ 6,561

Original Deposit in BOA

Deposit in CSB
Deposit in Sovereign Bank
Deposit in Citibank
Deposit in Capital One

Total New Deposits

$10,000
$ 9,000
$ 8,100
$ 7,290
$ 6,561

Original Deposit in BOA

Deposit in CSB
Deposit in Sovereign Bank
Deposit in Citibank
Deposit in Capital One

Money Multiplier Process

Deposit Loan
Deposit Loan
Deposit Loan
. . . . etc.

Total Change in Deposits

1
Total Deposits Initial Deposit
R
where R = the reserve requirement

If E = the percentage of their deposits banks

are holding as excess reserves

1
Total Deposits Initial Deposit
R+E
1
is called the "money multiplier"
R+E

Total Change in the Money Supply

1
Total Deposits Initial Deposit
R+E
1
is called the "money multiplier"
R+E
Money Supply

Total Deposits

Cash held by the public

Two Fundamental Equations of

Money Creation
1
Total Deposits Initial Deposit
R+E

Money Supply

Total Deposits

Cash held by the public

Total Change in Deposits

Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 0%

Total Deposits

1
Initial Deposit
R+E
1
$10,000
.1+0
$10,000 10
$100,000

Total Change in Deposits

Example:
and Money Supply
1
Total Deposits Initial Deposit
R+E
$100,000
Money Supply

Total Deposits

Cash held by the public

$100,000
$90,000

($10,000)

Excess Reserves Before

and During the Crisis

Total Change in Deposits

Example:
and Money Supply
What if E = 10%?
R still = 10%

1
Money multiplier
R+E
1

.1+.1
1

.2
5

Total Change in Deposits

Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 10%

Total Deposits

1
Initial Deposit
R+E
1
$10,000
.1+.1
$10,000 5
$50,000

Total Change in Deposits

Example:
and Money Supply
1
Total Deposits Initial Deposit
R+E
$50,000
Money Supply

Total Deposits

Cash held by the public

$50,000
$40,000

($10,000)

Reverse Money Multiplier Process

What happens if somebody withdraws
$10,000 from the bank?
Sets in motion the reverse money
multiplier process

Someone Withdraws $10,000 from

Bank of America
Assets (A)
Reserves $10,000
Actual Reserves
by $10,000

Bank is $9,000
short of reserves

Liabilities (L)
Deposits $10,000
Required Reserves
by $1,000
Bank Capital
(= A L)

Reverse Money Multiplier Process

Four options when a bank is short of reserves:
1. Borrow the needed reserves from another
bank on the Fed Funds market
2. Borrow the needed reserves from the Fed at
the discount window
3. Reduce loans
4. Sell securities (bonds)

Eventually, some bank will need to do (3) or (4)

Bank of America
Assets (A)

Liabilities (L)

Reserves +$9,000
Loans $9,000
Bank Capital
(= A L)

Citizens Bank
Assets (A)
Reserves $9,000

Liabilities (L)
Deposits $9,000

Bank is $8,100
short of reserves
Bank Capital
(= A L)

Sovereign Bank
Assets (A)
Reserves $8,100

Liabilities (L)
Deposits $8,100

Bank is $7,290
short of reserves
Bank Capital
(= A L)

Reverse Money Multiplier Process

Withdrawal Loan reduction
Withdrawal Loan reduction
Withdrawal Loan reduction
. . . . etc.

Total Change in Deposits

Example:
and Money Supply
$10,000 Deposit
R = 10%
E = 0%

Total Deposits

1
Initial Deposit
R+E
1
$10,000
.1+0
$10,000 10
$100,000

Reverse Money Multiplier

Example:
Process
$10,000 Withdrawal
R = 10%
E = 0%

Total Deposits

1
Initial Deposit
R+E
1
$10,000
.1+0
$10,000 10

Reverse Money Multiplier

Example:
Process
1
Total Deposits Initial Deposit
R+E
$100,000
Money Supply

Total Deposits

Cash held by the public

$100,000
$90,000

$10,000