Introduction
In my earlier newsletter, in which I discussed business finance, I explained that I worked as a credit analyst in a local bank. In that position, I analyzed the financial statements of the bank’s business customers. I did not realize until later that it did not prepare me to understand the balance sheet of the organization for which I worked.
The finances of a bank are significantly different than those of most businesses. Bank accounting uses many of the same terms used in business accounting, for example, assets, liabilities, and cash. In banks, these categories relate to each other in a significantly different manner.
Because of the similarity in these terms, I believe there exist common misconceptions about how banks actually operate. I will explain some of the differences in this newsletter.
As with my publication on business balance sheets, I have provided the following diagram.
The Basics
Similar to the business balance sheet, the balance sheet of a bank reflects the financial condition at a single point in time. Also, similar to a business, the bank balance sheet reflects the sources and uses of funds. Those sources and uses, however, have a significantly different relationship than they do with most businesses.
I will use a slightly different format than I did with the business finances by discussing assets first, then liabilities and equity.
Assets
Cash
Reserve Dollars at the Fed
$10 million
Like a business, banks usually have an account labeled “cash.” This account represents one of the significant differences between a bank and a business. Businesses can transfer the claims represented by their cash account to any entity they choose. The cash account at a bank, however, represents the “reserve dollars” held at the Federal Reserve Bank. Banks cannot transfer these dollars to any entity that does not have a membership in the Federal Reserve System. For this reason, they don’t meet one of the major requirements of “money:” general acceptance.
Long-Term (Medium-Term)
Customer Notes
$170 Million
Government Securities
$30 Million
The two largest groups of long-term (and medium-term) assets consist of customer notes and government securities.
People still refer to bank “loans.” I believe that the use of this term creates a lot of confusion among people discussing bank operations. The word “loan” seems to imply that the bank gives something in its possession to the “loan customer.” The actual transaction consists of the exchange of the customer’s note for a dollar-denominated claim. This distinction has more significance than would appear on the surface, as I will explain in the next section.
Deposit Liabilities
Immediate
Demand Accounts
$185 Million
Long-Term
Certificates of Deposit (CDs)
$20 Million
People still refer to the accounts they have at banks as “deposits.” Bank customer’s accounts actually reflect deposit liabilities. These liabilities account for any physical good placed in the custody of the bank. They simply represent dollar-denominated claims.
When a bank buys a customer’s note, it creates a dollar-denominated claim out of nothing. This deposit liability does not represent a claim on any of the bank’s assets. As confusing as it seems, this dollar-denominated claim represents only a claim on yet another dollar-denominated claim. (I will address the nature of money claims sometime in the future.)
Most deposit liabilities represent claims of an immediate nature. The customer should be able to transfer his claim to another person or entity without any notification to the bank. For this reason, I have adopted the phrase “money dollars.”
I referred to deposit liabilities of a longer term as “non-money dollars.” Customers cannot use them as a generally accepted medium of indirect exchange.
Risk Assessment
In my publication about business finance, I stated that people who held liabilities from the company had to do a risk assessment before they made their investments. The same does not hold true of modern banking institutions. Banks have charters that authorize them to issue dollar-denominated claims that have no relationship to the assets owned by the bank. Banks have FDIC insurance on a limited amount of deposit liabilities, but you might want to consider that somewhat of a joke. If a broad-based run on banks occurred, the FDIC has no way of covering those claims. We saw this in the financial meltdown of 2008. Holders of deposit liabilities do not have the capability nor the authorization to assess the risks of assets purchased by their banks, yet they still bore some of that risk.
Despite the lack of connection between deposit liabilities and bank assets, bank regulators still seem to want to hold depositors in jeopardy. In the recent example of the Silicon Valley Bank, several commentators said that deposit liability holders were at risk of losing some or all of their deposit claims.
The current banking system needs a lot of restructuring, but as long as the current system exists, holders of deposit liabilities should not bear the risk of bad decisions by bank management or poor markets for the assets of banks. I would recommend that deposit liabilities have the guarantee of the federal government. It would cost the government nothing, but it would give confidence to holders of deposit liabilities and expose the fact that asset risks expose only shareholders.
Equity
$5 million
Relative to other forms of businesses, banks have very small equity-to-asset ratios. In my made-up example, the equity amounts to roughly 2.5% of total assets. It would take only $5 million worth of losses to wipe out the capital of this bank.
I may have made the bank equity too small in my example, but if you do any research, you’ll find that it wouldn’t take too many write-offs to wipe out bank equity.
Total: Assets, Liabilities and Equity
$210 million
As usual, total assets must equal total liabilities and equity
Conclusion
I want readers to understand three basic points that make the finances of banks significantly different than other businesses:
- Because they cannot transfer any of their (cash) reserve balances to an outside entity, those reserves do not act as money.
- Holders of deposit liabilities should not bear the risks caused by bank management or markets.
- People should understand the relatively poor financial condition of all banks.
Before we can have any intelligent conversations about money and banking we must first understand the true structure of the banking system.