Banking and Management of Financial

Institutions

Reference: The Economics of Money, Banking, and

Financial Markets by Mishkin

Indraprastha Institute of Information Technology, Delhi

February 12th, 2025

Instructor: Kiriti Kanjilal Banking and Management of Financial Institutions

The Bank Balance Sheet
• Total assets = Total liabilities + Bank capital (banks’
net worth)
• A bank acquires funds by issuing (selling) liabilities, which
are consequently also referred to as sources of funds.

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Liabilities
• Checkable Deposits: Checkable deposits are bank
accounts that allow the owner of the account to write
checks to third parties.
• Checkable deposits include all accounts on which checks
can be drawn.
• A checkable deposit is an asset for the depositor because
it is part of his or her wealth. Conversely, because the
depositor can withdraw from an account funds that the
bank is obligated to pay, checkable deposits are a liability
for the bank.

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Liabilities
• Nontransaction Deposits: Owners cannot write checks
on nontransaction deposits, but the interest rates are
usually higher than those on checkable deposits.
• Fixed/Time deposits
• Time deposits have a fixed maturity length, ranging from
several months to over five years, and have substantial
penalties for early withdrawal

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Liabilities
• Borrowings: Banks obtain funds by borrowing from the
Central Bank, other banks, and corporations.
• Borrowings from the Central bank are called discount
loans (also known as advances).
• Banks also borrow reserves from other banks and financial
institutions.
• Federal (fed) funds market in the U.S

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Liabilities
• Bank Capital: The final category on the liabilities side of
the balance sheet is bank capital, the bank’s net worth,
which equals the difference between total assets and
liabilities.
• Bank capital is a cushion against a drop in the value of its
assets, which could force the bank into insolvency

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The Bank Balance Sheet
• Assets:
– Reserves
– Cash items in process of collection
– Deposits at other banks
– Securities
– Loans
– Other assets

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Assets
• Reserves: All banks hold some of the funds they acquire
as deposits in an account at the Central bank.
• Banks hold reserves for two reasons.
• First, some reserves, called required reserves, are held
because of reserve requirements, the regulation that for
every dollar of checkable deposits at a bank, a certain
fraction (10 cents, for example) must be kept as reserves.

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Assets
• This fraction (10 percent in the example) is called the
required reserve ratio.
• Banks hold additional reserves, called excess reserves,
because they are the most liquid of all bank assets and
can be used by a bank to meet its obligations when funds
are withdrawn, either directly by a depositor or indirectly
when a check is written on an account.

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Assets
• Cash Items in Process of Collection: Suppose that a
check written on an account at another bank is deposited
in your bank and the funds for this check have not yet
been received (collected) from the other bank.
• The check is classified as a cash item in process of
collection, and it is an asset for your bank because it is a
claim on another bank for funds that will be paid within a
few days.

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Assets
• Deposits at Other Banks: Many small banks hold
deposits in larger banks in exchange for a variety of
services, including check collection, foreign exchange
transactions, and help with securities purchases.
• This is an aspect of a system called correspondent
banking.

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 Assets
• Securities: A bank’s holdings of securities are an
important income-earning asset.
• Securities (made up entirely of debt instruments for
commercial banks, because banks are not allowed to hold
stock)

**Under the provisions of Section 19(2) of the Banking Regulation Act, 1949, a banking company cannot hold shares in any company
whether as pledgee or mortgagee or absolute owner of an amount exceeding 30 per cent of the paid-up share capital of that company
or 30 per cent of its own paid-up share capital and reserves, whichever is less. Besides, the investment by a bank in a subsidiary
company, financial services company, financial institution, stock and other exchanges should not exceed 10 per cent of the bank’s
paid-up share capital and reserves and the investments in all such companies, financial institutions, stock and other exchanges put t
ogether should not exceed 20 per cent of the bank’s paid-up share capital and reserves.
****See https://www.rbi.org.in/commonman/english/Scripts/Notification.aspx?Id=905

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Assets
• Loans: Banks make their profits primarily by issuing loans.
• A loan is a liability for the individual or corporation
receiving it, but an asset for a bank, because it provides
income to the bank.
• Loans also have a higher probability of default than other
assets.
• Because of the lack of liquidity and higher default risk, the
bank earns its highest return on loans.

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Assets
• Other Assets: The physical capital (bank buildings,
computers, and other equipment) owned by the banks is
included in this category.

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 Basic Banking
• Cash Deposit:

First Blank Blank Blank First Blank Blank Blank

National National
Bank Bank
Assets Blank Liabilities Blank Assets Blank Liabilities Blank
Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100
cash deposits deposits

• Opens a checking account with a $100 bill. She now has a

$100 checkable deposit at the bank, which shows up as a
$100 liability on the bank’s balance sheet. The bank now
puts her $100 bill into its vault so that the bank’s assets
rise by the $100 increase in vault cash.

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Basic Banking
• Check Deposit:
• If Jane had opened her account with a $100 check written on an
account at another bank, say, the Second National Bank, we would get
the same result.
• The First National Bank is owed $100 by the Second National Bank.
This asset for the First National Bank is entered in the T-account as
$100 of cash items in process of collection.

First National Bank Blank Blank Blank

Assets Blank Liabilities Blank

Cash items in process of +$100 Checkable +$100

collection deposits

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 Basic Banking
Check Deposit:
When a bank receives additional deposits, it gains an equal
amount of reserves; when it loses deposits, it loses an equal
amount of reserves.

First National Bank Blank Blank Blank Second National Blank Blank Blank
Bank
Assets Blank Liabilities Blank
Assets Blank Liabilities Blank

Reserves +$100 Checkable +$100 Reserves −$100 Checkable −$100

deposits deposits

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Basic Banking
• Let’s return to the situation when the First National Bank
has just received the extra $100 of checkable deposits.
• The bank is obliged to keep a certain fraction of its
checkable deposits as required reserves.
• If the fraction (the required reserve ratio) is 10%, the First
National Bank’s required reserves have increased by $10.

First National Blank Blank Blank

Bank
Assets Blank Liabilities Blank

Required +$10 Checkable +$100

reserves deposits
Excess reserves +$90 Blank Blank

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Basic Banking
• The bank must put to productive use all or part of the $90
of excess reserves it has available.
• Let us assume that the bank chooses not to hold any
excess reserves but to make loans instead.
• The bank is now making a profit because it holds short-
term liabilities such as checkable deposits and uses the
proceeds to buy longer-term assets such as loans with
higher interest rates.
• This process of asset transformation is frequently
described by saying that banks are in the business of
“borrowing short and lending long.”

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Basic Banking
• Making a profit:

First National Blank Blank Blank

Bank

Assets Blank Liabilities Blank

Required +$10 Checkable +$100

reserves deposits

Loans +$90 Blank Blank

• Asset transformation: selling liabilities with one set of

characteristics and using the proceeds to buy assets with a
different set of characteristics
• The bank borrows short and lends long

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General Principles of Bank Management
• The bank must have enough ready cash to pay its
depositors when there are deposit outflows, that is, when
deposits are lost because depositors make withdrawals
and demand payment.
• To keep enough cash on hand, the bank must engage in
liquidity management, the acquisition of sufficiently liquid
assets to meet the bank’s obligations to depositors.

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General Principles of Bank Management
• The bank manager must pursue an acceptably low level of
risk by acquiring assets that have a low rate of default and
by diversifying asset holdings (asset management).
• The third concern is to acquire funds at low cost (liability
management).
• Finally, the manager must decide the amount of capital the
bank should maintain and then acquire the needed capital
(capital adequacy management).

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General Principles of Bank Management
• How a financial institution manages credit risk, the risk
arising because borrowers may default, and how it
manages interest-rate risk, the riskiness of earnings and
returns on bank assets that results from interest-rate
changes.

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General Principles of Bank Management
• Liquidity Management
– Acquisition of assets that are liquid enough

• Asset Management
– Acquiring assets with a low risk of default

• Liability Management
– Acquisition of funds at low cost

• Capital Adequacy Management

• Credit Risk
• Interest-rate Risk

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Liquidity Management and the Role of
Reserves
• Excess reserves:
Assets Blank Liabilities Blank

Reserves $20M Deposits $100M

Loans $80M Bank Capital $10M

Securities $10M Blank Blank

• Suppose that the First National Bank’s initial balance sheet

• The bank’s required reserves are 10% of $100 million, or
$10 million.
• Since it holds $20 million of reserves, the First National
Bank has excess reserves of $10 million.

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Liquidity Management and the Role of
Reserves
• Excess reserves:
Assets Blank Liabilities Blank

Reserves $10M Deposits $90M

Loans $80M Bank Capital $10M

Securities $10M Blank Blank

• If a deposit outflow of $10 million occurs, the bank’s balance sheet.

• The bank loses $10 million of deposits and $10 million of reserves, but
since its required reserves are now 10% of only $90 million ($9
million), its reserves still exceed this amount by $1 million.
• In short, if a bank has ample reserves, a deposit outflow does not
necessitate changes in other parts of its balance sheet.

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Liquidity Management and the Role of
Reserves
• Shortfall:
Assets Blank Liabilities Blank

Reserves $10M Deposits $100M

Loans $90M Bank Capital $10M

Securities $10M Blank Blank

• The situation is quite different when a bank holds

insufficient excess reserves
• Let’s assume that instead of initially holding $10 million in
excess reserves, the First National Bank makes loans of
$10 million, so that it holds no excess reserves.

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Liquidity Management and the Role of
Reserves
• Shortfall:
Assets Blank Liabilities Blank

Reserves $0 Deposits $90M

Loans $90M Bank Capital $10M

Securities $10M Blank Blank

• When it suffers the $10 million deposit outflow, its balance sheet
becomes.
• After $10 million has been withdrawn from deposits and hence
reserves, the bank has a problem: It has a reserve requirement of 10%
of $90 million, or $9 million, but it has no reserves!

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Liquidity Management and the Role of
Reserves
• Shortfall:
• To eliminate this shortfall, the bank has four basic options. One is to
acquire reserves to meet a deposit outflow by borrowing them from
other banks in the federal funds market or by borrowing from
corporations.
• If the First National Bank acquires the $9 million shortfall in reserves
by borrowing it from other banks or corporations, its balance sheet
becomes:
• The cost of this activity is the interest rate on these borrowings

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M

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Liquidity Management and the Role of
Reserves
• Securities sale:
• A second alternative is for the bank to sell some of its
securities to help cover the deposit outflow.
• The bank incurs some brokerage and other transaction
costs when it sells these securities.
Assets Blank Liabilities Blank
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M Blank Blank

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Liquidity Management and the Role of
Reserves (5 of 7)
• Federal Reserve:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank capital $10M

– Borrowing from the Fed also incurs interest payments

based on the discount rate.

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Liquidity Management and the Role of
Reserves
• Federal Reserve:
• A third way that the bank can meet a deposit outflow is to acquire
reserves by borrowing from the Fed.
• The cost associated with discount loans is the interest rate that must
be paid to the Fed

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank capital $10M

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Liquidity Management and the Role of
Reserves

• Reduce loans:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M Blank Blank

• Finally, a bank can acquire the $9 million of reserves to

meet the deposit outflow by reducing its loans by this
amount and depositing the $9 million it then receives with
the Fed, thereby increasing its reserves by $9 million

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Liquidity Management and the Role of
Reserves

• Reduce loans:

Assets Blank Liabilities Blank

Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M Blank Blank

– Reduction of loans is the most costly way of

acquiring reserves.
– Calling in loans antagonizes customers.
– Other banks may only agree to purchase loans at a
substantial discount.

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Liquidity Management and the Role of
Reserves
• Excess reserves are insurance against the costs
associated with deposit outflows.
• The higher the costs associated with deposit outflows, the
more excess reserves a bank will want to hold.

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Asset Management
To maximize its profits, a bank has to
1. Seek the highest possible returns on loans and
securities.
2. Reduce risk.
3. Have adequate liquidity.

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Asset Management
Four Tools:
1. Find borrowers who will pay high interest rates and
have low possibility of defaulting.
2. Purchase securities with high returns and low risk.
3. Lower risk by diversifying.
4. Balance need for liquidity against increased returns
from less liquid assets.

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