Bank Management and Regulation: Balance Sheet, Risk, and Capital Rules
The balance sheet
Assets: reserves and cash items, securities, loans (largest, least liquid, highest-yielding), and fixed assets. Liabilities: checkable deposits, savings and time deposits, borrowings. Equity capital is assets minus liabilities - the loss-absorbing cushion. Profitability links through the equity multiplier: ROE = ROA × (assets ÷ equity).
Managing four risks
- Liquidity risk - meeting withdrawals without fire-selling assets; tools are reserves, credit lines, and the discount window.
- Credit risk - default; managed by screening, diversification, collateral, and covenants.
- Interest-rate risk - repricing mismatch. Gap analysis compares rate-sensitive assets and liabilities (an income effect); duration measures price sensitivity (a value effect).
- Capital risk - absorbing losses without insolvency.
Regulation
Deposit insurance (FDIC, $250,000 per depositor, per bank, per ownership category) stops runs but creates moral hazard, countered by supervision, capital standards, and prompt corrective action. Basel III sets common equity tier 1, tier 1, and total capital ratios plus a leverage ratio and liquidity coverage ratio. CAMELS rates capital, asset quality, management, earnings, liquidity, and sensitivity to market risk. Glass–Steagall (1933) separated commercial from investment banking; Gramm–Leach–Bliley (1999) repealed it; Dodd–Frank (2010) added stress tests, the Volcker rule, and resolution plans. The Fed acts as lender of last resort, and too-big-to-fail concerns persist for systemic firms.
Worked example
A bank holds $1,000 million in assets, $920 million in liabilities, and $80 million in equity, with ROA of 1%. ROE = 1% × (1,000/80) = 12.5%. A $60 million loan loss cuts equity to $20 million: the bank stays solvent, but its leverage ratio falls from 8% to 2%, likely triggering supervisory action.
Traps
Confusing ROA with ROE; assuming more capital always hurts shareholders without weighing the risk reduction; forgetting deposit insurance limits are per depositor, per institution, per ownership category; mixing gap analysis (income) with duration (value).