Banking is a unique business and banks are a very important institution to the efficient functioning of the financial system. What are the various components of the banks balance sheet? What are the different assets and liabilities in their balance sheet? Deposits are assets for anyone investing it, but how deposits accepted by a bank are represented in Bank's balance sheet? Explore answers to these questions and understand the significance of items that are generally part of the balance sheet of a commercial bank. Understand the business model of commercial banking from an accountant’s perspective.
As we have discussed in the earlier article that commercial banking is a business and banks play a role by providing a service and they earn a profit by charging customers for that service. The key commercial banking activities are taking in deposits from savers and making loans to households and firms. We also discussed how the bank makes profits by receiving funds from depositors and giving them on higher interest to the borrowers. In this article, we will look at the balance sheet items of commercial banks; will explain the items that come under bank’s sources of funds and the items where these funds may be applied. And finally how these items are summarized on its balance sheet.
A balance sheet is a statement that shows an individual’s or a firm’s financial position on a particular day. Learn more about Balance Sheet under General Ledger Tutorials. Balance sheet sheets show monetary values for each entry expressed in terms of currency of the market in which bank is registered. The typical layout of a balance sheet has liabilities on one site and assets shown on the other side and is based on the following accounting equation:
Assets = Liabilities + Shareholders’ equity
The accounting equation tells us that the left side of a firm’s balance sheet must always have the same value as the right side. We can think of a bank’s liabilities and its capital as the sources of its funds, and we can think of a bank’s assets as the uses of its funds.
Shareholders’ equity is the difference between the value of a firm’s assets and the value of its liabilities. Bank capital, also called shareholders’ equity, or bank net worth, is the difference between the value of a bank’s assets and the value of its liabilities. Shareholders’ equity represents the dollar amount the owners of the firm would be left with if the firm were to be closed, its assets sold, and its liabilities paid off. For a public firm, the owners are the shareholders. Shareholders’ equity is also referred to as the firm’s net worth. In banking, shareholders’ equity is usually called bank capital. Bank capital is the funds contributed by the shareholders through their purchases of the bank’s stock plus the bank’s accumulated, retained profits.
A liability is something that an individual or a firm owes, or, in other words, a claim on an individual or a firm. A liability, in financial terms, is a cash obligation. The most important bank liabilities are the funds a bank acquires from savers. Have you ever wondered if these deposits a form of bank income? Actually not, as the money received as deposits, does not really belong to the bank. For banks, deposits are liabilities. Depositors have the right to request their funds, and the bank must pay them. The bank is liable to pay this money back to the depositors on demand. The bank uses the funds to makes investments or loans to borrowers. Banks offer a variety of deposit accounts because savers have different needs. Money the bank borrowed is also a liability, a debt to be paid.
Note: You may not like to think of your savings account as a problem for the bank, but it is one in theory. As explained below, all the deposits are payable on demand, means, depositors can ask for payback of their money at any time and if depositors simultaneously want all their money from all their accounts, banks would be in trouble. In such a case, the bank must either break its promise to depositors or pay until its reserves are gone. If the bank fails, unpaid depositors lose their money. The bank's liquidity depends on this principle and is based on the assumption that depositors will not demand their money quickly. A bank's liabilities exceed its reserves. The money is loaned out, and the reserves do not match the total of deposits (liabilities). However, the money is out working, financing businesses and expanding the economy.
An asset is anything of value. An asset is something of value that an individual or a firm owns. In financial terms, that usually means money. A liquid asset is anything that can readily be exchanged, like cash. A bank's assets are its loans and investments, which may be less liquid by contract than deposits. Deposits may have to be returned any time, but assets can arrive in small amounts over a long period. Banks, like people and other corporations, make money on investments. They invest in stock markets and some types of securities and government bonds. While investing their money in instruments other than government bonds, they face the same risks as other investors. They hire professional investment staff to maximize their return on investments. Investments are assets for the banks.
A bank's liabilities are more liquid than its assets. A bank must give depositors their money if they request it. The bank's assets, however, may be less liquid because they are tied up in longer-term loans or investments, so the bank cannot get them as quickly.
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