Principles of Banking & Management
208
PART III
Financial Institutions
with higher interest rates. As mentioned earlier, this process of asset transformation is frequently described by saying that banks are in the business of “borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a 5% interest rate and it costs another $3 per year to service the account, the cost per year of these deposits is $8. The bank’s profit on the new deposits is then $1 per year (a 1% return on assets).
General Principles of Bank Management
The decisions made acquisition of
A bank’s deposits
Losses of decision by a bankthe maintainof assetsat low cost a low about that have to when depositors make funds to amount sufficient shouldassets rate of default demand capital it liquid withdrawals or and increase profits. to meet the bank’s diversification of asset maintain payment. and then obligations to the holdings to increase acquisition of depositors. profits. capital. needed The risk arising from possible reduction in returns associated the possibility that the with changes in interest borrower will default. rates. Liquidity
Management
and the Role of
Reserves
Now that you have some idea of how a bank operates, let’s look at how a bank manages its assets and liabilities in order to earn the highest possible profit. The bank manager has four primary concerns. The first is to make sure that the bank has 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.
Second, the bank manager must pursue an acceptably low level of risk by
PART III
Financial Institutions
with higher interest rates. As mentioned earlier, this process of asset transformation is frequently described by saying that banks are in the business of “borrowing short and lending long.” For example, if the loans have an interest rate of 10% per year, the bank earns $9 in income from its loans over the year. If the $100 of checkable deposits is in a NOW account with a 5% interest rate and it costs another $3 per year to service the account, the cost per year of these deposits is $8. The bank’s profit on the new deposits is then $1 per year (a 1% return on assets).
General Principles of Bank Management
The decisions made acquisition of
A bank’s deposits
Losses of decision by a bankthe maintainof assetsat low cost a low about that have to when depositors make funds to amount sufficient shouldassets rate of default demand capital it liquid withdrawals or and increase profits. to meet the bank’s diversification of asset maintain payment. and then obligations to the holdings to increase acquisition of depositors. profits. capital. needed The risk arising from possible reduction in returns associated the possibility that the with changes in interest borrower will default. rates. Liquidity
Management
and the Role of
Reserves
Now that you have some idea of how a bank operates, let’s look at how a bank manages its assets and liabilities in order to earn the highest possible profit. The bank manager has four primary concerns. The first is to make sure that the bank has 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.
Second, the bank manager must pursue an acceptably low level of risk by