{"id":579,"date":"2015-05-07T20:48:56","date_gmt":"2015-05-07T20:48:56","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterymacro1xngcxmaster\/?post_type=chapter&p=579"},"modified":"2016-07-28T20:25:17","modified_gmt":"2016-07-28T20:25:17","slug":"the-role-of-banks","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-hccc-macroeconomics\/chapter\/the-role-of-banks\/","title":{"raw":"Reading: The Role of Banks","rendered":"Reading: The Role of Banks"},"content":{"raw":"

The Role of Banks<\/h2>\r\nThe late bank robber named Willie Sutton was once asked why he robbed banks. He answered: \u201cThat\u2019s where the money is.\u201d While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.\r\n\r\nBanks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if all payments had to be made in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.\r\n\r\nBanks are a critical intermediary in what is called the payment system<\/em>, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual that is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash.\u00a0Transaction costs<\/em> are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries\u2014they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in the creation of money.\r\n

Banks as Financial Intermediaries<\/span><\/h2>\r\nAn \u201cintermediary\u201d is one who stands between two other parties. Banks are a financial intermediary<\/em>\u2014that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but they will not be included in this discussion because they are not considered to be depository institutions<\/em><\/a>, which are institutions that accept money deposits<\/em><\/span> and then use these to make loans. All the funds deposited are mingled in one big pool, which is then loaned out. Figure\u00a013.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.\r\n\r\n[caption id=\"attachment_4560\" align=\"aligncenter\" width=\"585\"]\"The Figure 13.4.<\/strong> Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.[\/caption]\r\n

HOW ARE BANKS, SAVINGS AND LOANS, AND CREDIT UNIONS RELATED?<\/h3>\r\nBanks have a couple of close cousins: savings institutions and credit unions. Banks, as explained, receive deposits from individuals and businesses and make loans with the money.\u00a0Savings institutions are also sometimes called \u201csavings and loans\u201d or \u201cthrifts.\u201d They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.\r\n\r\nA credit union<\/em> is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.\r\n\r\nIn 2008, there were 7,085 banks. Due to the bank failures of 2007\u20132009 and bank mergers, there were 5,844 banks in the United States at the end of the third quarter in 2013. According to Bankrate, there were 7,351 credit unions in the United States in 2012 with average assets of $20 million. A day of \u201cTransfer Your Money\u201d took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 million. However, as of 2013, the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve.\r\n

A Bank\u2019s Balance Sheet<\/span><\/h2>\r\nA balance sheet<\/em> is an accounting tool that lists assets and liabilities. An asset<\/em> is something of value that is owned and can be used to produce something. For example, the cash you own can be used to pay your tuition. If you own a home, this is also considered an asset. A liability<\/em> is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth<\/em> is the asset value minus how much is owed (the liability). A bank\u2019s balance sheet operates in much the same way. A bank\u2019s net worth is also referred to as bank capital<\/em>. A bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called \u201creserves\u201d), loans that are made to customers, and bonds.\r\n\r\nFigure\u00a013.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under \u201cAssets\u201d and \u201cLiabilities,\u201d it is sometimes called a T-account<\/em>.\r\n\r\n[caption id=\"attachment_4561\" align=\"aligncenter\" width=\"757\"]\"The Figure\u00a013.5.<\/b>\u00a0A Balance Sheet for the Safe and Secure Bank[\/caption]\r\n\r\n
<\/div>\r\nThe \u201cT\u201d in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank\u2014like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank\u2019s T-account, assets will always equal liabilities plus net worth.\r\n\r\nWhen bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example shown in Figure\u00a013.5, the Safe and Secure Bank holds $10 million in deposits.\r\n\r\nLoans are the first category of bank assets shown in Figure\u00a013.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank\u2019s perspective, because the borrower has a legal obligation to make payments to the bank over time. But in practical terms, how can the value of the mortgage loan that is being paid over 30 years be measured in the present? One way of measuring the value of something\u2014whether a loan or anything else\u2014is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. The market where loans are made to borrowers is called the primary\u00a0loan market<\/em>, while the market in which these loans are bought and sold by financial institutions is the secondary loan market.\r\n\r\nOne key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the characteristics of the borrower, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will be repaid? The greater the risk that a loan will not be repaid, the less that any financial institution will pay to acquire the loan.\u00a0Another key factor is to compare the interest rate charged on the original loan with the current interest rate in the economy. If the original loan made at some point in the past requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they were sold to other financial institutions in the secondary market is $5 million.\r\n\r\nThe second category of bank asset is bonds<\/em>, 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\u2014typically 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.\r\n\r\nThe final entry under assets is reserves<\/em>, which is money that the bank keeps on hand, and that is not loaned out or invested in bonds\u2014and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors\u2019 money on \u201creserve,\u201d 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.\r\n\r\nThe net worth of a bank is defined as its total assets minus its total liabilities. For the Safe and Secure Bank shown in Figure\u00a013.5, 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.\r\n\r\nhttps:\/\/youtu.be\/ViX4isDx8VY\r\n\r\n \r\n

How Banks Go Bankrupt<\/span><\/h2>\r\nA 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.\r\n\r\nA 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\u2019s 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 Figure\u00a013.5 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 a negative net worth.\r\n

WHAT LED TO THE FINANCIAL CRISIS OF 2008\u20132009?<\/h3>\r\nMany banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are \u201csecuritized,\u201d which means that they are bundled together into a financial security that is sold to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.\r\n\r\nSecuritization<\/em> offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. But if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid being exposed to local financial risks. (In the simple example in the text, banks just own \u201cbonds.\u201d In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have lots of extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can be pooled into a financial security.\r\n\r\nBut securitization also offers one potentially large disadvantage. If a bank is going to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the loan is likely to be repaid. However, a bank that is going to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what are called \u201csubprime loans,\u201d which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments after that. Some subprime loans<\/em> made in the mid-2000s were later dubbed NINJA loans: loans made even though the borrower had demonstrated No Income, No Job, nor Assets.\r\n\r\nThese subprime loans were typically sold and turned into financial securities\u2014but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.\r\n\r\nThe economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. But as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could end up being worth much less than they had expected\u2014and so the banks were staring bankruptcy in the face. In the 2008\u20132011 period, 318 banks failed in the United States.\r\n

Loan Defaults<\/h2>\r\nThe risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank\u2019s liabilities, namely the deposits of its customers, can be withdrawn quickly, but many of the bank\u2019s assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatch<\/em>\u2014a bank\u2019s liabilities can be withdrawn in the short term while its assets are repaid in the long term\u2014can 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.\r\n\r\nHow 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<\/em> its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market\u2014say, 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.\r\n\r\nAlong 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.\r\n

Self Check: Banks<\/h2>\r\nAnswer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not<\/strong> count toward your grade in the class, and you can retake it an unlimited number of times.\r\n

You\u2019ll have more success on the Self Check if you\u2019ve completed the Reading in this section.<\/span><\/p>\r\nUse this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.\r\n\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/555","rendered":"

The Role of Banks<\/h2>\n

The late bank robber named Willie Sutton was once asked why he robbed banks. He answered: \u201cThat\u2019s where the money is.\u201d While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.<\/p>\n

Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if all payments had to be made in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.<\/p>\n

Banks are a critical intermediary in what is called the payment system<\/em>, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual that is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash.\u00a0Transaction costs<\/em> are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries\u2014they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in the creation of money.<\/p>\n

Banks as Financial Intermediaries<\/span><\/h2>\n

An \u201cintermediary\u201d is one who stands between two other parties. Banks are a financial intermediary<\/em>\u2014that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but they will not be included in this discussion because they are not considered to be depository institutions<\/em><\/a>, which are institutions that accept money deposits<\/em><\/span> and then use these to make loans. All the funds deposited are mingled in one big pool, which is then loaned out. Figure\u00a013.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.<\/p>\n

\"The<\/p>\n

Figure 13.4.<\/strong> Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.<\/p>\n<\/div>\n

HOW ARE BANKS, SAVINGS AND LOANS, AND CREDIT UNIONS RELATED?<\/h3>\n

Banks have a couple of close cousins: savings institutions and credit unions. Banks, as explained, receive deposits from individuals and businesses and make loans with the money.\u00a0Savings institutions are also sometimes called \u201csavings and loans\u201d or \u201cthrifts.\u201d They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.<\/p>\n

A credit union<\/em> is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.<\/p>\n

In 2008, there were 7,085 banks. Due to the bank failures of 2007\u20132009 and bank mergers, there were 5,844 banks in the United States at the end of the third quarter in 2013. According to Bankrate, there were 7,351 credit unions in the United States in 2012 with average assets of $20 million. A day of \u201cTransfer Your Money\u201d took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 million. However, as of 2013, the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve.<\/p>\n

A Bank\u2019s Balance Sheet<\/span><\/h2>\n

A balance sheet<\/em> is an accounting tool that lists assets and liabilities. An asset<\/em> is something of value that is owned and can be used to produce something. For example, the cash you own can be used to pay your tuition. If you own a home, this is also considered an asset. A liability<\/em> is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth<\/em> is the asset value minus how much is owed (the liability). A bank\u2019s balance sheet operates in much the same way. A bank\u2019s net worth is also referred to as bank capital<\/em>. A bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called \u201creserves\u201d), loans that are made to customers, and bonds.<\/p>\n

Figure\u00a013.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under \u201cAssets\u201d and \u201cLiabilities,\u201d it is sometimes called a T-account<\/em>.<\/p>\n

\"The<\/p>\n

Figure\u00a013.5.<\/b>\u00a0A Balance Sheet for the Safe and Secure Bank<\/p>\n<\/div>\n

<\/div>\n

The \u201cT\u201d in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank\u2014like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank\u2019s T-account, assets will always equal liabilities plus net worth.<\/p>\n

When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example shown in Figure\u00a013.5, the Safe and Secure Bank holds $10 million in deposits.<\/p>\n

Loans are the first category of bank assets shown in Figure\u00a013.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank\u2019s perspective, because the borrower has a legal obligation to make payments to the bank over time. But in practical terms, how can the value of the mortgage loan that is being paid over 30 years be measured in the present? One way of measuring the value of something\u2014whether a loan or anything else\u2014is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. The market where loans are made to borrowers is called the primary\u00a0loan market<\/em>, while the market in which these loans are bought and sold by financial institutions is the secondary loan market.<\/p>\n

One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the characteristics of the borrower, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will be repaid? The greater the risk that a loan will not be repaid, the less that any financial institution will pay to acquire the loan.\u00a0Another key factor is to compare the interest rate charged on the original loan with the current interest rate in the economy. If the original loan made at some point in the past requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they were sold to other financial institutions in the secondary market is $5 million.<\/p>\n

The second category of bank asset is bonds<\/em>, 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\u2014typically 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.<\/p>\n

The final entry under assets is reserves<\/em>, which is money that the bank keeps on hand, and that is not loaned out or invested in bonds\u2014and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors\u2019 money on \u201creserve,\u201d 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.<\/p>\n

The net worth of a bank is defined as its total assets minus its total liabilities. For the Safe and Secure Bank shown in Figure\u00a013.5, 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.<\/p>\n