Criminal defense in Austin Texas.

Banking for Dummies

Posted By on February 14, 2009

Banks are run according to the following simple equation:

Assets (including reserves) = liabilities + equity.

Assets are anything that has value.  In the case of banks, it’s mainly the money they’ve lent out, plus the interest they hope to collect on it.  It also includes reserves, the bit of cash they keep on hand to cover day to day operations.

Liabilities are whatever the bank owes to others, including all the deposits it’s collected from you and me, plus whatever other money it’s borrowed.

Equity is the variable.  It’s what’s left over after liabilities have been subtracted from assets.

Equity = assets – liabilities.

Equity is the bank’s net worth, and because it’s net worth, it’s also the part of the bank that belongs to the shareholders.  Everything else belongs to somebody else – either depositors or shareholders.

If assets less liabilities is zero, or less than zero, then the bank is insolvent.

You can think of a bank as two towers of money, each of which must always match the other. If the value of one changes, so must the other.

Assets = Liabilities + Equity

Assets = Liabilities + Equity

To take a simple example, suppose a bank buys a pile of gold for $1000, with money it’s borrowed from the public.  The value of its assets, then, is $1000, the same as its liabilities.  If gold increases to $1500 per pile, then the bank gains $500 in equity, which its accountants will duly note in its records.  If gold later falls to $500 per pile, then the bank is insolvent.

This is the simple case.

Suppose, however, instead of buying gold, the bank makes loans to the public.  In that case, the bank’s assets are the same as the value of the loans it’s made.

Now loans, just like gold, have a market, and the market value of loans changes, just as it does for gold.

When the value of a bank’s loans (or “portfolio”) goes up, the bank is quick realize the change, and quick to tell everybody about it.  It’s a bit slower, on the other hand, the move happens in the opposite direction.

In fact, if the move is significant – enough to wipe out the bank’s equity – the bank may choose not to recognize it all.  Perhaps there’s “no market,” for the loans.  Maybe the markets are “distressed.”  Or perhaps the bankers have chosen to hold the loans “to maturity,” so the market value doesn’t matter.

In any event, it’s the bankers themselves who decide.

And as a practical matter, there’s nothing to stop them from losing money indefinitely, so long as they have the support of a central bank, or the government.


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