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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can be especially difficult for banks because a bank’s liabilities, namely the deposits of its customers, can be withdrawn quickly, but many of the bank’s assets like loans and bonds will only be repaid over years or even decades.This asset-liability time mismatch —a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term—can cause severe problems for a bank.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 objective of macroecnomics in shortrun and long run?
Kalpajyoti Reply
hmm to see how things wages and other economic i dicators adjust in short and long run
Amjad
What economic values calculate the rate of inflation?
Prabha
change in cpi
Amjad
Thank you
Prabha
'You can't compare apples to oranges' an old adage, yet GDP exactly does that, anyone please to show how?
Marvin Reply
2. Mention the change if any in supply or demand or both with drawing: 1. The effect of introduction of breathable nail polish in Islamic countries on the sales of ordinary nail polish. 2. The effect on subscription if OSN is offering free receivers for new subscribers. 3. The effect on sales o
Radwaaa Reply
list three possible ways of addressing and adverse balance of payment
Meribah Reply
when MPs is 0.3 and autonomous consumption is 30billion what is d consumption expenditure
queen Reply
what is macroeconomic?
Shahidul
Consumption expenditure becomes: C = 30b + 0.3Y without lump sum tax and C = 30b + 0.3Yd with lump sum tax
olumide
Macroeconomics deals with the study of the behavior of aggregate individuals, firms or government in an economy in relation to consumption patterns and decision making
olumide
If the government decrases spending by ksh. 500 billion what is the change in output given MPC is 0.75
Gichana Reply
375
Philip
how can policy makers strike the balance between inflation and unemployment?
Oreva Reply
I dunno
Azeez
c=800 + 0.75y i=500 G=900 compute the equilibrium level of national output
Omar Reply
y=c+I+g+(X-M) y=800+.75y+500+900+0 y-.75y=2200 .25y=2200 y=2200/.25 y=8800=national level of output
Anik
Please tell me the current crr, repo rate etc
Ranjeeta Reply
cash reserve ratio is the amount that is deposit by the commercial bank in Central bank.... n repo rate is a loan interest amount
Sahar
what is slr madam sahar
Rohit
jo amount bank reserve rakhti hai bank mai customers k liye jese ATM mai ya bank mai rakha hota hai, wo slr hota hai
Sahar
pakka sahi hai
Rohit
good joke
Rohit
Argentina Lose !!😭😭
MR.ASHIM
SLR refers to that portion of total deposits of a commercial bank which it has to keep with itself in the form of cash reserve
Ranjeeta
What is cash crop?
Ranjeeta Reply
commeciaal crops
Amal
So jowar is not cash crop?
Ranjeeta
anything which is plant inorder to sell in the market
Simeon
How demand deposits are different from savings?
Ranjeeta
can unemployment be a factor of inflation?
David Reply
yeah it has an impact on cost push inflation
Vincent
yes ,unemployment is a factor of inflation and it is cost push inflation
Silu
Is phillip curve still applicable in today's economy?
Jestony
what has changed?
Qiniso
statistics show that Philip curve doesn't reflect reality all the time
Or
which causes to be inflation and deflation?
li
yes it is a factor of inflation . low unemployment results in high inflation and high unemployment results in low unemployment
Rishav
Could you explain me more?
li
In your question you use the word " can" ... So this exist as a possibility...
karoline
who can explain more about phillip's curve?
Jestony
Philip's curve shows that to achieve low employment. there must be high rate of price and this can be achieved by govt. policy - fiscal and monetary policy.
orgbu
microeconomics is individual firms and macroeconomics is a large as a full
kendra Reply
That's true 👍
Kwibuka
word micro means small and tiny part. word macro means large and big part.
saddiq
Exactly
Emmanuel
is unemployment another cause of inflation?
David
can I say unemployment can cause inflation?
David
no. unemployment can possibly lead to deflation
Asdfghjkl
if their are no production am I correct to say inflation will occurs
David
one of the causes of inflation is excess demand. if there's no production there would be no demand so no inflation
Asdfghjkl
if we take a look at inflation, it occur because of low production. High price chasing few goods.
David
So are you saying demand creates supply?
David
to an extent because if s9mething is demanded, it's likely to be supplied
Asdfghjkl
OK am still confused, if there is unemployment low production, and employment high production, inflation high increase in price, how can production be high and we are faced with inflation? When inflation is referred to higher price chasing few goods.
David
if the demand is increased , what is the graphics on it?
Tadesse Reply
what is macroeconomics
Prosenjit Reply
large-scale economics, such as interest rates or the gross national national product rate of of a country
Michael
Macroeconomics: is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.
Khadar
well said
Michael
hello everyone, would like to ask a favor... i need your help to answer this problem: Assume that equilibrium GDP is 400B; potential GDP is 500B, the marginal propensity to consume is 9/10, the interest rate is 8%, investment spending is P20B, the money supply is 120B, and the reserve requirement
Jerelyn
is 1/10. By how much and in what direction should the Fed change the monetary base?
Jerelyn
what are the factors that influence surplus budget? and its effects
Christopher Reply
what is credit creation
Christopher
join
Christopher

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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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