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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can be especially difficult for banks because a bank’s liabilities, namely the deposits of its customers, can be withdrawn quickly, but many of the bank’s assets like loans and bonds will only be repaid over years or even decades.This asset-liability time mismatch —a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term—can cause severe problems for a bank.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 is barter system
twinkel Reply
a system in which goods are exchanged for other goods
daniel
Barter system is said to be the process whereby goods are being exchange for goods
Asamoah
a system in which money have not play any role
Ramu
goods and services are exchanged .. problem is finding equitable or agreeable value for the exchange of the goods or services.. I teach maths privately and love home made cake, I decided 4 home made cakes was worth an hour of private maths 😁
jax
ok.thank u
twinkel
thanks a lot to everyone .
ISRAR
accounts in balance of trade
Kamuyu Reply
What is fiscal policy and intrest rates
Attah Reply
fiscal policy is the use of govt. revenue collection and expenditure to influence the economy.
twinkel
income and expenditure
Bittu Reply
Macro economics : it is the study of all aggregate of all economic activities of an economic as whole.
Rajat Reply
what is macro economics
Sarah Reply
it is study of all aggregate of all economic activities of an economic as whole.
Rajat
Macro economics is the aggregate study of national income, investment, price level, changes in economic activities, GDP and economic inflation.
Zahid
hey
Ahmed
how are you
Ahmed
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Ahmed
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Ahmed
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Ahmed
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Ahmed
what is comparative and superlative advantage? give an example
Xanaan Reply
Methods used to correct trade deficits?
David Reply
what is role capitalism unemployment?
Mafsuud Reply
being unemployment look job but not achieved their being out labor force is person can't work
Mafsuud
being unemployment look job but not achieved their being out labor force is person can't work
Mafsuud
themes studied in economics include?
Patrick Reply
Financial accounting GDP and GNP
Samson Reply
can u explain
Sarah
this means that the demand curve have negative relationship with the price ..which means that when high price low demand of the product and vice versa so higher price will shirnk the demand of product
Ahsan Reply
Higher price level ∴Real value of household wealth increase ∴Net export decrease ∴More money needed, interest rate increase, investment decrease
sirius
net export decrease
Cyril
a person has 60birr to buy two commodities,x and y the price of x is four birr unit the price of y is two birr unit his utility functio given by u=xy+2x determine the budget equation
Mohammed Reply
the budget equation will be- 60 birr= 4x+2y
Ramu
What are the various reasons for the Federal Reserve to increase the fed rates?
AMEEN Reply
What is unemployment
Mijash Reply
Unemployment is a term used to describe people who do not hold a paying job
JASON
what are the causes of unemployment
evans
unemployment refer to the situation in which people searching job but they have no. it also refers in which marginal productivity in zero.
Ramu
Causes of unemployment are: 1: Over Population 2: Break down of the family system 3: Rural/Urban Migration
Umar
unemployment simply means, in the situation where by people are looking for a job and their could achieve it.
Faruk
unemployment is a situation where by one has the ability to work but is not given a job
Sarah

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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