The Banking Firm and its Management
The Bank Balance Sheet
Simplified Balance Sheet
Reserves 6% Deposits 70%
Loans 60% Non-deposit Liabilities 25%
Government Bonds 23% Bank Capital 5%
1. Basic operation of a Bank
Banks are involved in what is known as asset transformation. They exchange their short-term liabilities
(i.e. savings deposits) for long-term assets (i.e. mortgage loans). Their primary objective is to generate profits
for their shareholders but as a by-product of their operations they create bank deposits (i.e. they affect the
They following simplified balance-sheet entries trace the effects of extending a bank loan to a business.
Assets Liabilities Assets Liabilities
Loans +100 Deposits +100 Deposits +100 Loans +100
The Banks also create deposits when they acquire non-income-producing assets such as cash
Deposit of $100 cash into a Bank
Value cash (Reserves) +100 Deposits +100
2. Principles of Bank Management
1.1 Liabilities Management
A Bank has to maintain excess reserves in order to be able to deal with unexpected deposit outflows.
Otherwise, it has to cover reserve shortfalls in a number of ways all of which involve costs for the bank.
To highlight different ways of covering reserve shortfall and the attendant costs we consider some
Suppose that the reserve requirement is 10% and a bank holds excess r