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The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely the deposits of its customers, can be withdrawn quickly, but many of the bank’s assets like loans and bonds will only be repaid over years or even decades.This asset-liability time mismatch —a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term—can cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that were made at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.

How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify    its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.

Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because a higher share of loans will not be repaid in tough economic times.

Key concepts and summary

Banks facilitate the use of money for transactions in the economy because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or being paid, and when saving money or receiving a loan. In the financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans. A balance sheet (sometimes called a T-account) is an accounting tool which lists assets in one column and liabilities in another column. The liabilities of a bank are its deposits. The assets of a bank include its loans, its ownership of bonds, and its reserves (which are not loaned out). The net worth of a bank is calculated by subtracting the bank’s liabilities from its assets. Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans, or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low rate of interest on its long-term loans but must pay the currently higher market rate of interest to attract depositors. Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves. If banks hold only a fraction of their deposits as reserves, then the process of banks’ lending money, those loans being re-deposited in banks, and the banks making additional loans will create money in the economy.

Problems

A bank has deposits of $400. It holds reserves of $50. It has purchased government bonds worth $70. It has made loans of $500. Set up a T-account balance sheet for the bank, with assets and liabilities, and calculate the bank’s net worth.

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References

Credit Union National Association. 2014. "Monthly Credit Union Estimates." Last accessed March 4, 2015. http://www.cuna.org/Research-And-Strategy/Credit-Union-Data-And-Statistics/.

Dallas Federal Reserve. 2013. "Ending `Too Big To Fail': A Proposal for Reform Before It's Too Late". Accessed March 4, 2015. http://www.dallasfed.org/news/speeches/fisher/2013/fs130116.cfm.

Richard W. Fisher. “Ending 'Too Big to Fail': A Proposal for Reform Before It's Too Late (With Reference to Patrick Henry, Complexity and Reality) Remarks before the Committee for the Republic, Washington, D.C. Dallas Federal Reserve. January 16, 2013.

“Commercial Banks in the U.S.” Federal Reserve Bank of St. Louis. Accessed November 2013. http://research.stlouisfed.org/fred2/series/USNUM.

Questions & Answers

what are the factors of production
Sheku Reply
capital, labor, technology
Lucas
is economic a science
Emmanuel Reply
as economic a science
Emmanuel
yes because it study human behavior
Ahmed
yes it deal with human activity and the welfare of people in the country
Nsobila
Is Economics a Science
Albert Reply
what is scarcity
Edmore Reply
Scarcity is the limitedness of resources relative to human wants. In economic sense means that the available resources are not sufficient to satisfy all human wants.
Innocent
Moreover, Fiscal policy deal with government revenue and expenditure. Government expenditure puts money in public hands while government revenue withdraws the money. Role of fiscal policy is to reduces money circulation as a means of reducing demand.
Innocent
What is an inflationary spiral?
Innocent
Suppose that you 're nominated as a Minister of Finance in your country's. How can you finance a deficit budget?
Innocent
is economic a science
Emmanuel
yes because we studying human behaviour
Umar
what are the factors of production
Sheku
pls Emmanuel adjei do we know each other
Hawa
Emmanuel adjei pls did u attend living God school
Hawa
Can you explain the terms 'fiscal deficit' and 'fiscal policy'?
Brahmani Reply
fiscal deficit refers to the government expenditure exceed expected to the government revenue
Innocent
fiscal deficit is like budget deficit
Innocent
fiscal policy it occurs when the government takes and maintain the strategic to resolve the inflation.
Innocent
What is inflation?
Braa Reply
increase in general price level
suresh
a sudden increase in prices of goods that effects our cost of living
Brahmani
what is Debenture in economy
Gideon Reply
what is economic
Vida Reply
Economic is a seines which study the human behavior as ends and scarce means which have alternative uses
Debrah
Economics is the study of how human make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions.
Wandji
Economics is a science that study human behaviour as a relationship between ends and scarce means which may have alternative uses.
Elizabeth
in my opinion, economics helps us to learn decision making not only in short term but in long term too
shubham
What is Debenture in economy
Gideon
what is special directives
Emmanuel Reply
what is demand
Joseph Reply
Demand simply refers to the amount of goods and services which the consumer is willing and able to purchase at each price
Owusu
Demand refers to the quantity of goods and services an individial is willing and able to purchase or buy at various price over a period of time
Elizabeth
what is mean by unitary elastic demand
Bangniyel Reply
demand is said to be unitary elastic when the percentage change in the demand is equal to the percentage change in the price
George
what is the principle of equi-marginal utility
Reliance Reply
what is Economics and it important
Anita Reply
what is production
Anita
what is Economic
Anita Reply
what is the meaning of Economic
Anita
economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses
Boso
I don't know.
natchanan
u don't
Ssali
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Raewyn
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Liambee
ya nyc
Ssali
Thanks kk
Anita
pls can I ask more questions
Anita
what is production
Anita
production is creation of goods and services
George
what is macroeconomics and microeconomics
Anita
macroeconomics deals with larger economic units such as GDP,GNP,employment while microeconomics deals with smaller economic units such firm and household
George
Thanks
Anita
Explain the ff Scarcity Ends Demand Supply Choice Scale of preference
Anita
macroeconomics deals with larger economic units such as GDP,GNP,employment while microeconomics deals with smaller economic units such firm and household
George
Gross Domestic product...it represent the total value of the products produced within the country including foreign industries
George Reply
what is products
Anita

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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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