Chapter 10
The Economics of Banking
Brief Chapter Summary and Learning Objectives 
10.1 The Basics of Commercial Banking: The Bank Balance Sheet (pages 280–289)
Understand bank balance sheets.
A bank’s balance sheet provides a summary of a bank’s sources and uses of funds.
Bank liabilities are the funds banks acquire from savers and use to make investments or to make
loans to borrowers.
A bank’s managers build a portfolio of assets that reflect both the demand for loans by the
bank’s customers and the bank’s need to balance returns against risk, liquidity, and information
costs.
Bank capital is the difference between the value of a bank’s assets and its liabilities.
10.2 The Basic Operations of a Commercial Bank (pages 289–293)
Describe the basic operations of a commercial bank.
Banks use deposits to acquire interest-bearing assets, which results in a profit if the interest
earned on the assets is sufficiently higher than the interest paid on deposits.
A bank’s profitability can be measured in several ways, including net interest margin, return on
assets, and return on equity.
10.3 Managing Bank Risk (pages 293–299)
Explain how banks manage risk.
Liquidity risk refers to the possibility that a bank may not be able to meet its cash needs by
selling assets or raising funds at a reasonable cost. Banks can reduce this risk by asset and
liquidity management.
Credit risk is the risk that borrowers might default on their loans. Banks can reduce this risk by
diversifying across borrowers, regions, and industries.
Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital.
Banks can reduce this risk by making variable-rate loans and using interest-rate swaps.
10.4 Trends in the U.S. Commercial Banking Industry (pages 299–307)
Explain the trends in the U.S. commercial banking industry.
The United States currently has a dual banking system in which banks can be chartered either by
state governments or by the federal government.
Congress created the Fed as a lender of last resort and the Federal Deposit Insurance
Corporation to reduce the likelihood of bank panics.
In recent decades, the government has lifted state and federal restrictions on banks giving rise to
nationwide banking.
Off-balance-sheet activities and electronic banking have expanded the boundaries of banking.
In response to the Financial Crisis of 2007–2009, Congress created the Troubled Asset Relief
Program (TARP), which injected funds into banks with the intent of avoiding a surge in bank
failures.
Key Terms 
Asset Something of value that an individual or a
firm owns; in particular, a financial claim.
Balance sheet A statement that shows an
individual’s or a firm’s financial position on a
particular day.
Bank capital The difference between the value
of a bank’s assets and the value of its liabilities;
also called shareholders’ equity.
Bank leverage The ratio of the value of a bank’s
assets to the value of its capital, the inverse of
which (capital to assets) is called a bank’s
leverage ratio.
Checkable deposits Accounts against which
depositors can write checks.
Credit rationing The restriction of credit by
lenders such that borrowers cannot obtain the
funds they desire at the given interest rate.
Credit risk The risk that borrowers might default
on their loans.
Credit-risk analysis The process that bank loan
officers use to screen loan applicants.
Dual banking system The system in the United
States in which banks are chartered by either a
state government or the federal government.
Duration analysis An analysis of how sensitive a
bank’s capital is to changes in market interest
rates.
Excess reserves Any reserves banks hold above
those necessary to meet reserve requirements.
Federal deposit insurance A government
guarantee of deposit account balances up to
$250,000.
Gap analysis An analysis of the difference, or
gap, between the dollar value of a bank’s
variable-rate assets and the dollar value of its
variable-rate liabilities.
Interest-rate risk The effect of a change in
market interest rates on a bank’s profit or capital.
Leverage A measure of how much debt an
investor assumes in making an investment.
Liability Something that an individual or a firm
owes, particularly a financial claim on an
individual or a firm.
Liquidity risk The possibility that a bank may not
be able to meet its cash needs by selling assets or
raising funds at a reasonable cost.
Loan commitment An agreement by a bank to
provide a borrower with a stated amount of funds
during some specified period of time.
Loan sale A financial contract in which a bank
agrees to sell the expected future returns from an
underlying bank loan to a third party.
National bank A federally chartered bank.
Net interest margin The difference between the
interest a bank receives on its securities and loans
and the interest it pays on deposits and debt,
divided by the total value of its earning assets.
Off-balance-sheet activities Activities that do not
affect a bank’s balance sheet because they do not
increase either the bank’s assets or its liabilities.
Prime rate Formerly, the interest rate banks
charged on six-month loans to high-quality
borrowers; currently an interest rate banks charge
primarily to smaller borrowers.
Required reserves Reserves the Fed requires
banks to hold against demand deposit and NOW
account balances.
Reserves A bank asset consisting of vault cash
plus bank deposits with the Federal Reserve.
Return on assets (ROA) The ratio of the value of
a bank’s after-tax profit to the value of its asset.
Return on equity (ROE) The ratio of the value of
a bank’s after-tax profit to the value of its capital.
Standby letter of credit A promise by a bank to
lend funds, if necessary, to a seller of commercial
paper at the time that the commercial paper
matures.
T-account An accounting tool used to show
changes in balance sheet items.
Troubled Asset Relief Program (TARP) A
government program under which the U.S.
Treasury purchased stock in hundreds of banks to
increase the banks’ capital.
Vault cash Cash on hand in a bank; includes
currency in ATMs and deposits with other banks.
Chapter Outline 
Teaching Tips
This chapter is a key one. It focuses on the role commercial banks play as intermediaries in the
saving-investment process and on how banks manage the risks involved in their deposit and lending
activities. Surprisingly, the idea that banks are privately owned, profit-making businesses comes as news
to some students. The chapter begins with a discussion of bank balance sheets. Most students will be
familiar with the basics of balance sheets from their principles of economics course. Those students who
have taken an introductory accounting course will have even greater familiarity with the topic.
Nevertheless, time spent reviewing the fundamentals of the definitions of assets and liabilities and how
assets and liabilities enter a balance sheet is generally well spent. In particular, the mechanics of
T–accounts can be mysterious to many students who have been exposed to the subject in their principles
course, but have not fully grasped it. The money creation process, illustrated with T-accounts, can be one
of the most difficult topics in the course, so it is generally worth making students comfortable with
T–accounts before they encounter that discussion in Chapter 14.
To Buy a House, You Need a Loan.
Teaching Tips
The chapter opener discusses how problems related to the financial crisis of 2007-2009 have made it more
difficult for borrowers to get loans. The discussion notes the effect of this difficulty on individual
borrowers as well as on monetary policy. Spending some class time covering this opener can help
students better understand how problems in the banking system can adversely affect the wider economy.
10.1 The Basics of Commercial Banking: The Bank Balance Sheet (pages 280–289)
Learning Objective: Understand bank balance sheets.
A bank’s balance sheet provides a summary of a bank’s sources and uses of funds. The balance
sheet illustrates the relationship among a bank’s assets, liabilities, and capital (or shareholders’
equity).
A. Bank Liabilities
Bank liabilities are the funds that banks acquire from savers, which the bank uses to make
investments or loans to borrowers. There are two types of checkable deposits:
1. Demand deposits, which do not pay interest.
2. NOW accounts, which do pay interest.
Nontransactions deposits consist of savings accounts, money market deposit accounts, and
certificates of deposits (CDs), also known as time deposits. CDs worth more than $100,000 can
be traded in secondary markets prior to maturity. Banks also can borrow from other banks in the
federal funds market, execute repurchase agreements with other financial firms, or take out
discount loans from the Federal Reserve. Repurchase agreements involve a bank selling a
security, while typically agreeing to buy it back the next day with interest.
B. Bank Assets
A bank’s managers build a portfolio of assets that reflect both the demand for loans by the
bank’s customers and the bank’s need to balance returns against risk, liquidity, and information
costs. The most liquid asset that banks hold is reserves, which can be held as vault cash or as
bank deposits at the Fed. Required reserves are the portion of demand deposits and NOW
accounts that the Fed requires banks to hold. Any reserves beyond what is required are called
excess reserves. Banks are allowed to hold marketable securities including those issued by the
U.S. Treasury and other government agencies, corporate bonds that were rated investment
grade when first issued, and a limited amount of municipal bonds. The largest asset of banks is
loans, which are illiquid and have higher information costs and default risk than marketable
securities. Other bank assets include physical assets and collateral received from borrowers
who have defaulted on loans.
C. Bank Capital
Bank capital is the difference between the value of a bank’s assets and its liabilities. Bank
capital includes funds obtained from purchases of stocks issued by the bank plus accumulated
retained profits.
10.2 The Basic Operations of a Commercial Bank (pages 289–293)
Learning Objective: Describe the basic operations of a commercial bank.
Banks use deposits to acquire interest-bearing assets, and earn a profit if the interest earned on the
assets is sufficiently greater than the interest paid on the deposits. To be successful, a bank must
make prudent loans and investments so that it earns a high enough rate of return to cover its costs
and to make a profit. Banks avoid large swings in reported losses and profits by setting aside loan
loss reserves in anticipation of future declines in the value of their loans.
A. Bank Capital and Bank Profits
A bank’s profitability can be measured in several ways. A bank’s net interest margin is the
difference between the interest it receives on its securities and loans and the interest it pays on
deposits and debt, divided by the total value of its earning assets. Return on assets (ROA) is the
ratio of the value of a bank’s after-tax profit to the value of its asset. Return on equity (ROE) is
the ratio of the value of a bank’s after-tax profit to the value of its capital. The ratio of assets to
capital is a measure of bank leverage because banks take on debt by, for instance, accepting
deposits to gain the funds they need to accumulate assets. Leverage can magnify small ROAs
into large ROEs (or small losses into large losses). Because depositors are shielded from losses
by federal deposit insurance and bank managers are compensated in part based on ROE, moral
hazard may result in higher bank leverage. Regulators deal with this risk by imposing capital
requirements on banks.
10.3 Managing Bank Risk (pages 293-299)
Learning Objective: Explain how banks manage risk.
A. Managing Liquidity Risk
Liquidity risk refers to the possibility that a bank may not be able to meet its cash needs by
selling assets or raising funds at a reasonable cost. Banks typically reduce liquidity risk through
asset management and liquidity management. Two options include:
1. Lending funds in the federal funds market for a day.
2. Engaging in reverse repurchase agreements.
Banks may also engage in liability management through:
1. Borrowing funds in the federal funds market.
2. Engaging in repurchase agreements.
3. Obtaining discount loans from the Fed.
B. Managing Credit Risk
Credit risk is the risk that borrowers might default on their loans. By diversifying across
borrowers, regions, and industries, banks can reduce their credit risk. In performing credit-risk
analysis, bank loan officers screen loan applicants to eliminate potentially bad risks and to
obtain a pool of creditworthy borrowers. To combat problems of adverse selection, banks also
generally require that a borrower put up collateral. In some circumstances, banks minimize the
costs of adverse selection and moral hazard through credit rationing in which banks limit the
size of a loan or refuse to lend any amount to some borrowers at the current interest rate. Banks
keep track of whether borrowers are obeying restrictive covenants or explicit provisions in the
loan agreement that prohibit the borrower from engaging in certain activities. One of the best
ways for a bank to gather information about a borrower’s prospects or to monitor a borrower’s
activities is for the bank to have a long-term business relationship with the borrower.
C. Managing Interest-Rate Risk
Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital.
Gap analysis looks at the difference between the dollar value of a bank’s variable-rate assets
and the dollar value of its variable-rate liabilities and can help a bank assess the effect of a
change in interest rates on its profits. Duration analysis is an analysis of how sensitive a bank’s
capital is to changes in market interest rates. A bank can use its duration gap, which is the
difference between the average duration of its assets compared to the average duration of its
liabilities, to gauge how much the value of its capital will decline if interest rates rise. Banks
can reduce interest-rate risk by making adjustable-rate loans and using interest-rate swaps.
10.4 Trends in the U.S. Commercial Banking Industry (pages 299-307)
Learning Objective: Explain the trends in the U.S. commercial banking industry.
A. The Early History of U.S. Banking
The United States currently has a dual banking system in which banks can be chartered either
by state governments or by the federal government. The National Banking Acts of 1863 and
1864 also prohibited banks from using deposits to buy ownership of nonfinancial firms
(which is not restricted in some other countries).
B. Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation
In the nineteenth and early twentieth centuries, if many banks simultaneously experienced runs,
the result would be a bank panic, which often resulted in banks being unable to return
depositors’ money and having to close their doors at least temporarily. In response to the Panic
of 1907, Congress created the Federal Reserve and assigned it the role of lender of last resort.
The bank panics of the early 1930s led Congress to create the Federal Deposit Insurance
Corporation (FDIC), which insures bank deposits up to a specific limit.
C. The Rise of Nationwide Banking
Historically, a series of federal laws prohibited interstate banking while many states prohibited
banks from operating more than one branch. Most economists think these restrictions made
banks inefficient because they could not take advantage of economies of scale. After the
mid-1970s, most states removed restrictions on branches; in the 1990s, the federal government
removed most restrictions on interstate banking. During and after the financial crisis of
2007-2009, there has been debate over whether restrictions should be imposed on the size of
banks because some banks are considered “too big to fail.”
D. Expanding the Boundaries of Banking
Banks have increasingly turned to generating fee income from off-balance-sheet activities,
including standby letters of credit, loan commitments, loan sales, and trading activity. Although
banks generate fee income from off-balance-sheet activities, they also take on additional risk.
In recent years, banks have made increasing use of virtual or online banking.
E. The Financial Crisis, TARP, and Partial Government Ownership of Banks
During the financial crisis of 2007-2009, the market for mortgage-backed securities froze,
making it very difficult to determine the market prices of these securities. The true value of
bank capital—or even whether a bank still had positive net worth—was difficult to determine.
During August and September 2007, banks responded to their worsening balance sheets by
tightening credit standards for consumer and commercial loans, which contributed to the severe
recession that began in December 2007. In October 2008, to deal with the problems banks were
facing, Congress passed the Troubled Asset Relief Program (TARP), which provided up to
$700 billion to be used to stabilize the banking system. A good portion of the funds were used
as capital injections into banks, resulting in partial government ownership. In return, banks had
to pay dividends of 5% of the value of the stock to the Treasury as well as to issue warrants that
allowed the Treasury to purchase additional shares up to 15% of the Treasury’s original
investment. Some policymakers and analysts criticized TARP as a bailout that increased moral
hazard or argued that TARP might lead banks to make loans based on political pressure.
Supporters of TARP argued that it was necessary given the fear that there would be a surge in
bank failures leading to another Great Depression. By late 2012, the TARP program had earned
a $21 billion profit.
Teaching Tips
You can use the Making the Connection, “Is Your Neighborhood ATM About to Disappear? on page 305
of the text to help students better understand the dynamic nature of the banking system. Ask students the
various ways they have engaged in banking in the last month (going to a bank branch, using an ATM,
electronic banking, and so on). Discuss the factors that are resulting in increased use of ATMs as well as
factors that are reducing the use of ATMs. This discussion should help students to see how what was once
considered an innovative way to do banking–ATMs–is being surpassed by new forms of banking, such as
electronic banking and mobile banking.