Bank Balance Sheet: Assets, Liabilities, and Bank Capital
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 on a specific date, 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 and liabilities are further distinguished as being either current or long-term. Current assets are assets expected to be sold or otherwise converted to cash within 1 year; otherwise, the assets are long-term (aka noncurrent assets). Current liabilities are expected to be paid within 1 year; otherwise, the liabilities are long-term (aka noncurrent liabilities). Working capital is the excess of current assets over current liabilities, a measure of its liquidity, meaning its ability to meet short-term liabilities:
Working Capital = Current Assets – Current Liabilities
Generally, working capital should be sufficient to meet current liabilities. However, it should not be excessive, since capital in the form of long-term assets usually has a higher return. The excess of the bank's long-term assets over its long-term liabilities is an indication of its solvency, its ability to continue as a going concern.
Assets: Uses of Funds
Assets earn revenue for the bank and includes cash, securities, loans, and property and equipment that allows it to operate.
Cash and Cash Equivalents
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 in 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 perform 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.
Cash equivalents are another short-term asset, so-called because they are nearly equivalent to cash: short-term investments that can either be used as cash or can be quickly converted to cash without loss of value, such as demand deposits, T-bills, and commercial paper. A primary characteristic of financial instruments that are classified as cash equivalents is that they have a short-term maturity of 3 months or less, so interest rate risk is minimal, and they are the most highly rated securities or issued by a government that can print its own money, such as the T-bills issued by the US government, so there is little credit risk.
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 their 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:
- business loans, usually called commercial and industrial (C&I) loans
- real estate loans
- residential mortgages
- home equity loans
- commercial mortgages
- consumer loans
- credit cards
- auto loans
- interbank loans
Liabilities: Sources of Funds
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 the 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, and it is these accounts that are credited or debited as money is transferred between banks. 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. Part of the reason for the 2007 - 2009 Credit Crisis is that banks didn't know which other banks were holding risky mortgage-backed securities that were beginning to default in large numbers, so they stopped lending to each other, forcing banks to restrict their lending to the public, which caused the supply of money to decline and the economy to contract.
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 2007 - 2009 credit risis 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. The number of banks has continually declined since 1990, while the share of assets of the 100 largest banks has exceeded 80%, with the 10 largest of those banks holding about 60% of those assets. (Source: Federal Reserve)
Simplified T-Account for Commercial Banks
The balance sheet of a bank can also be represented by a T-account, often used in accounting textbooks to emphasize that debits and credits must balance, where the left side lists debits and the right side lists credits. In accounting, assets are classified as debits and liabilities and owners equity, which in this case is bank capital, are classified as credits. (Although listing assets as debits and liabilities as credits seems counterintuitive, the classification is arbitrary, since the only purpose of debits and credits in accounting is that the total of these 2 must equal. This helps to avoid or to correct many entry and other accounting mistakes.) The 2 sides of the T-account must equal; in other words, the value of the left side must equal the value of the right side. Below is a simplified version of a T-account for a typical bank, which summarizes the information provided above:
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New Accounting Rules for Valuing Assets
Bank capital (= total assets – 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. Additionally, banks also didn't have to write down assets that they intended to keep to maturity. 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 could also record income on their books if the market value of their debt declines. 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 though the bank would have to pay the principal back when the debt matures.
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 have been reduced to a $2.5 billion loss under the old accounting rules. Hence, Citigroup enjoyed a gain of $4.1 billion simply by changing the accounting rules!