27.3 The role of banks  (Page 4/28)

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.

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.