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The second category of bank asset is bonds , which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued by the U.S. government. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million.

The final entry under assets is reserves    , which is money that the bank keeps on hand, and that is not loaned out or invested in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or kept at the Federal Reserve Bank. This is called a reserve requirement. ( Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding $2 million in reserves.

The net worth of a bank is defined as its total assets minus its total liabilities. For the Safe and Secure Bank shown in [link] , net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.

For some concrete examples of what banks do, watch this video from Paul Solman’s “Making Sense of Financial News.”

How banks go bankrupt

A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.

A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the expenses of banks every year includes a factor for loans that are not repaid, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some loans will not be repaid. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in [link] experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.

Questions & Answers

what is demand
Gooluck Reply
demand is the willingness to purchase something
Mohamed
demand is the potential ability or williness to purchases something at a particular price at a given period of time..
Ahmed
what is demand
John Reply
is the production of goods in scarcity
David
thanks
John
what is demand of supply
music Reply
What is the meaning of supply of labour
Anthonia Reply
what is production?
Elizabeth Reply
Production is basically the creation of goods and services to satisfy human wants
Anthonia
under what condition will demand curve slope upward from left to right instead of normally sloping downward from left to right
Atama Reply
how i can calculate elasticity?
Tewekel Reply
What is real wages
Emmanuella Reply
what are the concept of cost
Tabitha Reply
what is the difference between want and choice
Grace Reply
Want is a desire to have something while choice is the ability to select or choose a perticular good or services you desire to have at a perticular point in time.
Dalton
substitutes and complements
Amman Reply
Substitute are goods that can replace another good but complements goods that can be combined together
nkanyiso
account for persistent increase in lnflation
niwahereza Reply
what is opportunity cost
Adebowale Reply
opportunity cost reffered to as alternative foregone when choice is made
niwahereza
government measures to control inflation?
Formu Reply
control populationk growth rate by using family planning to reduce faster increase of people than job creation
niwahereza
how do we calculate the firm's profit maximizing output in the short run given marginal cost ,average cost and average variable costs?
Nomuhle Reply

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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