A balance sheet (aka statement of condition, statement of financial position) is a financial report that shows the value of a company's assets, liabilities, and owner's equity at a specific period of time, usually at the end of an accounting period, such as a quarter or a year. An asset is anything that can be sold for value. A liability is an obligation that must eventually be paid, and, hence, it is a claim on assets. The owner's equity in a bank is often referred to as bank capital, which is what is left when all assets have been sold and all liabilities have been paid. The relationship of the assets, liabilities, and owner's equity of a bank is shown by the following equation:
Bank Assets = Bank Liabilities + Bank Capital
A bank uses liabilities to buy assets, which earns its income. By using liabilities, such as deposits or borrowings to finance assets such as loans to individuals or businesses, or to buy interest earning securities, the owners of the bank can leverage their bank capital to earn much more than would otherwise be possible using only the bank's capital.
Assets earn revenue for the bank and includes cash, securities, loans, and property and equipment that allows it to operate.
One of the major services of a bank is to supply cash on demand, whether it is a depositor withdrawing money or writing a check, or a bank customer drawing on a credit line. A bank also needs funds to pay bills, but while bills are predictable in both amount and timing, cash withdrawals by customers are not.
Hence, a bank must maintain a certain level of cash compared to its liabilities to maintain solvency. A bank must hold some cash as reserves, which is the amount of money held in a bank's account at the Federal Reserve (Fed). The Federal Reserve determines the legal reserves, which is the minimum amount of cash that banks must hold in their accounts to ensure the safety of banks and also allows the Fed to effect monetary policy by adjusting the reserve level. Often, banks will keep excess reserves for greater safety.
To do business at its branches and automated teller machines (ATMs), a bank also needs vault cash, which includes not only cash in its vaults, but also cash elsewhere on a bank's premises, such as teller drawers, and the cash in its ATM machines.
Some banks, usually smaller banks, also have accounts at larger banks, called correspondent banks. which are usually larger banks that often borrow from the smaller banks or performs services for them. This relationship makes lending expeditious because many of these smaller banks are rural and have excess reserves whereas the larger banks in the cities usually have a deficiency of reserves.
Another source of cash is cash in the process of collection. When a banks receives a check, it must present the check to the bank on which it is drawn for payment, and, previously, this has taken several days. Nowadays, checks are being processed electronically and many transfers of funds are being conducted electronically instead of using checks. So this category of cash is diminishing significantly, and will probably disappear when all financial transactions finally become electronic.
The primary securities that banks own are United States Treasuries and municipal bonds. These bonds can be sold quickly in the secondary market when a bank needs more cash, so they are often referred to as secondary reserves.
The recent credit crisis has also underscored the fact that banks held many asset-backed securities as well. United States banks are not permitted to own stocks, because of the risk, but, ironically, they can hold much riskier securities called derivatives.
Loans are the major asset for most banks. They earn more interest than banks have to pay on deposits, and, thus, are a major source of revenue for a bank. Often banks will sell the loans, such as mortgages, credit card and auto loan receivables, to be securitized into asset-backed securities which can be sold to investors. This allows banks to make more loans while also earning origination fees and/or servicing fees on the securitized loans.
Loans include the following major types:
Liabilities are either the deposits of customers or money that banks borrow from other sources to use to fund assets that earn revenue. Deposits are like debt in that it is money that the banks owe to the customer but they differ from debt in that the addition or withdrawal of money is at the discretion of the depositor rather than dictated by contract.
Checkable deposits are deposits where depositors can withdraw the money at will. These include all checking accounts. Some checkable deposits, such as NOW, super-NOW, and money market accounts pay interest, but most checking accounts pay very little or no interest. Instead, depositors use checking accounts for payment services, which, nowadays, also includes electronic banking services.
Before the 1980s, checkable deposits were a major source of cheap funds for banks, because they paid little or no interest on the money. But as it became easier to transfer money between accounts, people started putting their money into higher yielding accounts and investments, transferring the money when they needed it.
Nontransaction deposits include savings accounts and time deposits, which are basically certificates of deposits (CDs). Savings accounts are not used as a payment system, which is why they are categorized as nontransaction deposits and is also the reason why they pay more interest. Savings deposits of yore were mostly passbook savings accounts, where all transactions were recorded in a passbook. Nowadays, technology and regulations have allowed statement savings where transactions are recorded electronically and may be viewed by the depositor on the bank's website or a monthly statement is mailed to the depositor; and money market accounts, which have limited check writing privileges and earn more interest than either checking or savings accounts.
A certificate of deposit (CD) is a time deposit where the depositor agrees to keep the money in the account until the CD expires. The bank compensates the depositor with a higher interest rate. Although the depositor can withdraw money before the CD expires, banks charge a hefty fee for this.
There are 2 types of certificates of deposit (CDs): retail and large. A retail CD is for less than $100,000 and is generally sold to individuals. It cannot be resold easily. Large CDs are for $100,000 or more and are highly negotiable so they can be easily resold in the money markets. Large negotiable CDs are a major source of funding for banks.
Nontransaction deposits in depository institutions are now insured to $250,000 by the Federal Deposit Insurance Corporation (FDIC).
Banks also borrow money, usually from other banks in what is called the federal funds market, so-called because funds kept in their reserve accounts at the Federal Reserve are called federal funds. Banks with excess reserves, which are usually smaller banks located in smaller communities, lend to the larger banks in metropolitan areas, which are usually deficient in reserves.
The interbank loans in the federal funds market are unsecured, so banks only lend to other banks that they trust. Banks also borrow from nondepository institutions, such as insurance companies and pension funds, but most of these loans are collateralized in the form of a repurchase agreement (aka repo), where the bank gives the lender securities, usually Treasuries, as collateral for a short-term loan. Most repos are overnight loans that are paid back with interest the very next day.
As a last resort banks can also borrow from the Federal Reserve (Fed), though they rarely do this since it indicates that they are under financial stress and unable to get funding elsewhere. However, during the credit freeze in 2008 and 2009, many banks borrowed from the Fed because they could not get funding elsewhere.
Banks can also get more funds either from the bank's owners or, if it is a corporation, by issuing more stock. For instance, 19 of the largest banks that received federal bailout money during the credit crisis raised $43 billion of new capital in 2009 by issuing stock because their reserves were deemed inadequate in response to stress testing by the United States Treasury.
| Graph spanning 1990 - 2007 showing how the number of banks has declined continuously, and how the share of all bank assets of the 10 largest and 100 largest banks has grown in the same time period. |
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| Source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default.htm |
Bank capital, which is equal to the value of total assets minus total liabilities, is the bank's net worth. However, recent accounting changes have made it more difficult to determine a bank's true net worth.
Banks were having a tough time in early 2009. The credit crisis has caused many defaults on mortgages, credit cards, and auto loans, forcing them to increase their loan loss reserves and to devalue many of the asset-backed securities that they held based on these loans. Consequently, banks were suffering major losses. A major contributor to these losses was because the asset-backed securities that were still held by the banks had to be valued by mark-to-market rules, and since no one was buying these toxic securities, their mark-to-market value was very low.
To restore confidence in the banking system, the government allowed some changes to the accounting rules that artificially increased the revenues of the banks. The Financial Accounting Standards Board (FASB) allowed banks to value their assets according to fair value, as determined by the banks. However, many critics assert that there will be more defaults on the underlying loans of these securities, and, thus, will have to be accounted for in the future.
Banks also didn't have to write down assets that they intended to keep to maturity. Here, again, critics argued that there will probably be many more defaults on the underlying loans, especially since the unemployment rate is still rising, so they will be forced to write them down in the future.
Additionally, banks could record income on their books if the value of the debt falls in the market. The reason for this allowance is because they could buy back their own debt in the market, thus reducing their debt for a fraction of its face value. However, critics have pointed out that if a bank doesn't have the money to buy back its debt, it could still record the reduced value as revenue even the bank would have to pay the principal back by the debt's maturity.
Citigroup is a good example of how much the new accounting rules can change the income reported by a bank. According to this Bloomberg article, the $1.6 billion profit reported by Citigroup under the new accounting rules for its 1st quarter in 2009 would be reduced to a $2.5 billion loss under the old accounting rules.
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