AlMoatassem Mostafa

Lecture Seven: November 2016

MONEY & BANKING

3. The Operation of Commercial

Banks

Credit RisksThe Balance

Sheet of Commercial

Banks

The Balance Sheet of

Commercial Banks

Liabilities Assets

A balance sheet contains all the operations conducted by a commercial bank. It is divided into two main sides.

The first side is allocated to assets, while the second one contains liabilities.

Commercial banks own assets on which they earn interest and have liabilities on which they pay interest.

All deposits are, therefore, listed as liabilities in a commercial bank’s balance sheet, while securities and loans are generally listed as assets in the balance sheet.

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A commercial bank’s liabilities include: Deposits; Borrowings; and Bank Capital.

In contrast, a commercial bank’s assets are generally composed of the following: Reserves; Cash items in process of collection; Securities; Loans; and Physical capital.

BALANCE SHEET

Liabilities

Deposits Borrowings

Bank’s Capital

Deposits, including transaction and nontransaction deposits, are regarded as liabilities to commercial banks because they are owned mainly by the depositors.

They, consequently, represent assets for the depositors.

They are also liabilities to commercial banks because depositors can withdraw funds from their accounts on demand and the bank is compelled to pay these funds

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A second liability on the balance sheet of a commercial bank is borrowing.

Commercial banks can borrow from the central bank, from other commercial banks, or from the private sector.

Loans borrowed from the central bank are called discount loans.

In addition, commercial banks borrow from each other in the federal funds market where commercial banks with excess reserves lend other commercial banks that are running short on reserves.

Borrowings are liabilities to commercial banks because they eventually have to repay them.

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Borrowings

Discount loans from central

bank

Loans from other

commercial banks

A commercial bank’s capital is the value of the shareholders’ investment in the bank.

A commercial bank is established mainly through selling stocks in its initial public offering.

When the bank operates and achieves profits, it is obligated to return a part of these profits to the shareholders as dividends. The rest of the profits is kept at the bank as retained earnings.

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Assets

ReservesCash items in process

of collection

Securities Loans Physical Capital

Reserves include a commercial bank’s deposits at the central bank plus vault cash.

All the commercial banks have deposits at the central bank because it is much easier to settle transactions between commercial banks through the central bank and no cash is required to be transferred between them.

Vault cash, in contrast, includes currency and coins held at a commercial bank’s vault. Although reserves pay no interest for commercial banks, the operation of commercial banks requires keeping these reserves.

Regulations that govern the activities of commercial banks require from them to keep a certain fraction for every Egyptian Pound of a checkable account. This kind of reserves is called required reserves.

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A BANK’S VAULT

The other type of reserves kept by commercial banks is called excess reserves; they keep these reserves in order to have enough liquidity to meet all the withdrawals from checkable accounts or in case of excessive withdrawals associated with public holidays, for instance.

RESERVES

Suppose you are selling an item for someone else and this person, who has a checkable account at HSBC, issues a check for you on his account.

If you have an account at Banque Misr, for instance, you will simply deposit this check at your bank, then your bank will claim this check from HSBC for you.

This process might take a couple of days, and during this period, the check is regarded as a cash item in process of collection because the funds have not been transferred to your account yet.

Cash items in process of collection is an asset for your bank because it is a claim on the funds that exist in another bank and that will be paid within a couple of days.

CASH ITEMS IN PROCESS OF COLLECTION

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CHECKS IN PROCESS OF COLLECTION

Commercial banks can also hold debt securities as assets.

These securities are issued either by the government, governmental organizations, private-sector corporations, or other commercial banks.

These debt securities are useful because commercial banks can obtain liquidity rapidly and at low cost by selling these securities at the market.

It must be noted, in addition, that securities held by commercial banks are restricted to debt securities rather than equity securities such as stocks.

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TREASURY BILLS

Loans are the most important asset for commercial banks because they are a major source of their profits.

Loans are assets for a commercial bank as a lender and liabilities for individuals and businesses as borrowers.

Loans are, however, the least liquid among all the other assets, because a bank can not obtain the loan until the loan is mature.

Banks are also vulnerable to the risk of nonpayment of loans; this explains why they impose higher interest rates on loans

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LOANS

All the bank buildings, computers, chairs, offices, and other instruments are also regarded as assets of a commercial bank.

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A BANK’S BALANCE SHEET

Assets Liabilities + Capital

Reserves 10

Securities 250

Loans 600

Physical Capital 70

Total Assets 930

Transaction Deposits 70

Nontransaction Deposits 500

Borrowings

150

Equity Capital 70

Total Liabilities + Capital 790

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