Asset, Liabilities and Net Worth

A persons wealth is an important aspect of their situation in the process of consumption

smoothing. Balance sheets are are an essential tool for understanding how wealth changes when
individual or firm borrows and lends. A balance sheet summarizes what the household, bank, or
firm owns and what it owes to others. Balance sheets help us to understand the relationships
between households and banks in the economy. Bank deposits make up part of the typical
household‘s assets and they appear on the liability side of the balance sheet of banks in the
economy. Another typical asset of a household is its house. Unless the household owns the house
outright, the household has a liability as well as an asset—the liability is the mortgage. The
mortgage, in turn, is an asset of the bank. The things you own (including what you are owed by
others) are called your assets, and the debts you owe others are called your liabilities (to be liable
means to be responsible for something, in this case to repay your debts to others). The difference
between your assets and your liabilities is called your net worth. The relationship between assets,
liabilities, and net worth is shown in Figure

Figure: A balance sheet.

When the components of an equation are such that by definition, the left-hand side is equal to the
right-hand side, it is called an accounting identity, or identity for short. The balance sheet
identity states:

assets≡liabilities+net worth

so,

Net worth = asset- liabilities

 Banks , Money and Central Bank
A bank is a financial institution that is licensed to accept checking and savings deposits and
make loans. Banks also provide related services such as individual retirement accounts (IRAs),
certificates of deposit (CDs), currency exchange, and safe deposit boxes. There are several types
of banks including retail banks, commercial or corporate banks, an investment banks. A bank is a
financial institution licensed to receive deposits and make loans. There are several types of banks
including retail, commercial, and investment banks. In most countries, banks are regulated by the
national government or central bank. The main purpose of commercial banks is to provide
financial services to the general public and also provide loan facilities to the business which
helps in ensuring economic stability and growth of the economy. Therefore, we can say that
credit creation is the most important purpose of commercial banks.

Major Type of Banks

 Central Bank.
 Cooperative Banks.
 Commercial Banks.
 Regional Rural Banks (RRB)
 Local Area Banks (LAB)
 Specialized Banks.
 Small Finance Banks.
 Payments Banks.

Maturity transformation is when banks take short-term sources of finance, such as deposits from
savers, and turn them into long-term borrowings, such as mortgages. Due to these characteristics
of deposits and loans, banks are engaging in what is called ―liquidity‖ or ―maturity
transformation‖ when they fund loans with deposits – funding long-term or illiquid assets with
short-term liabilities. For all these reasons, loan rates are generally above deposit rates.

Liquidity Risk in Banks and Business,

Liquidity risk is the risk that a Bank or individual will not have enough cash to meet its financial
obligations (pay its debts) on time. Liquidity refers to the ease at which an asset can be converted
into cash without negatively affecting its market price; the risk arises when a company cannot
buy or sell an investment in exchange for cash fast enough to pay its debts. Liquidity is the
ability of a firm, company, or even an individual to pay its debts without suffering catastrophic
losses. Investors, managers, and creditors use liquidity measurement ratios when deciding the
level of risk within an organization. If an individual investor, business, or financial institution
cannot meet its short-term debt obligations, it is experiencing liquidity risk.

What is Default Risk?

Default risk, also called default probability, is the probability that a borrower fails to make full
and timely payments of principal and interest, according to the terms of the debt security
involved. Together with loss severity, default risk is one of the two components of credit risk.
Default risk is the type of risk that measures the chances of not fulfilling the obligations such as
non-repayment of principal or interest and is mathematically calculated based on the past
commitments, financial conditions, market conditions, liquidity position and present obligations,
etc. Many factors affect default like heavy losses suffered, blockage of money in long term
assets, poor cash flow and financial position, economic conditions like recession, etc. It is
measured by the ratings issued by the credit rating agencies.

What Is a Bank Run?

A bank run occurs when a large number of customers of a bank or other financial institution
withdraw their deposits simultaneously over concerns of the bank's solvency. As more people
withdraw their funds, the probability of default increases, prompting more people to withdraw
their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the
withdrawals. Bank runs happen when a large number of people start making withdrawals from
banks because they fear the institutions will run out of money. A bank run is typically the result
of panic rather than true insolvency. A bank run triggered by fear that pushes a bank into actual
insolvency represents a classic example of a self-fulfilling prophecy. The bank does risk default,
as individuals keeping withdrawing funds. So what begins as panic can eventually turn into a
true default situation.

The Central Bank, The Money Market and Interest Rates

The term commercial bank refers to a financial institution that accepts deposits, offers checking
account services, makes various loans, and offers basic financial products like certificates of
deposit (CDs) and savings accounts to individuals and small businesses. A commercial bank is
where most people do their banking. Commercial banks make money by providing and earning
interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer
deposits provide banks with the capital to make these loans.

Significance of Commercial Banks

Commercial banks are an important part of the economy. Not only do they provide consumers
with an essential service, but they also help create capital and liquidity in the market. They
ensure liquidity by taking the funds that their customers deposit in their accounts and lending
them out to others. Commercial banks play a role in the creation of credit, which leads to an
increase in production, employment, and consumer spending, thereby boosting the economy.As
such, commercial banks are heavily regulated by a central bank in their country or region. For
instance, central banks impose reserve requirements on commercial banks. This means banks are
required to hold a certain percentage of their consumer deposits at the central bank as a cushion
if there's a rush to withdraw funds by the general public. Short term interest rate is the price of
borrowing base money.

what are the determinants of price of borrowing in the money market ?

1. the demand for base money depends on how many transactions commercial banks to
make
 2. the supply of base money is simply a decision by central bank

The monetary base (or M0) is the total amount of a currency that is either in general circulation
in the hands of the public or in the form of commercial bank deposits held in the central bank's
reserves. This measure of the money supply is not often cited since it excludes other forms of
non-currency money that are prevalent in a modern economy.

The policy interest rate is set by the central bank, and it is the most important rate since it
influences all other interest rates in the economy. The policy interest rate is the rate at which the
central bank will pay or charge commercial banks for their deposits or loans. Bank rate can be
defined as the rate of interest that is charged by a central bank while lending or giving loans to a
commercial bank. A bank can borrow money from the central bank of a country if it is
insufficient in funds. In India's case, the central bank would be the Reserve Bank of India.

The repo rate is the interest rate at which the Reserve Bank of India (RBI) loans money to
commercial banks. Repo is an abbreviation for Repurchase Agreement or Repurchasing Option.
Banks obtain loans from the Reserve Bank of India (RBI) by selling qualifying securities.

Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in
case of India) borrows money from commercial banks within the country. It is a monetary policy
instrument which can be used to control the money supply in the country.

Financial System
What Is a Financial System?

A financial system functions as an intermediary between savers and investors. It facilitates the
flow of funds from the areas of surplus to the areas of deficit. It is concerned about the money,
credit and finance. These three parts are very closely interrelated with each other and depend on
each other.
A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges,that permit the exchange of funds. Financial systems exist on firm, regional, and
global levels. Broadly there are two categories of Indian Financial System, i.e. Indian Money
market and Indian capital Market: Indian Money Market – in which short term funds are lent and
borrowed. Indian Capital Market – where medium and long term exchanges happen.
Treasury bills, also known as T-bills, are short term government bonds. They are issued for
maturity within one year.

Present value (PV) is the current value of a future sum of money or stream of cash flows given a
specified rate of return. Present value takes the future value and applies a discount rate or the
interest rate that could be earned if invested.

Net present value (NPV) is a financial metric that seeks to capture the total value of an
investment opportunity. The idea behind NPV is to project all of the future cash inflows and
outflows associated with an investment, discount all those future cash flows to the present day,
and then add them together.

What is a balance sheet in banking? Balance Sheet is the financial statement of a company which
includes assets, liabilities, equity capital, total debt, etc. at a point in time. Balance sheet includes
assets on one side, and liabilities on the other. A balance sheet (sometimes called a statement of
financial position) is a summary of all your business assets (what the business owns) and
liabilities (what the business owes). It can show you how much money you would have left over
if you sold all your assets and paid off all your debts (owners' equity).

The biggest expense item for a bank is the interest expense. Usually, the amount of deposit
amount increases due to policies of the bank and the interest expense would also increase.

The main operations and source of revenue for banks are their loan and deposit operations.
Customers deposit money at the bank for which they receive a relatively small amount of
interest. The bank then lends funds out at a much higher rate, profiting from the difference in
interest rates.

Liabilities and Assets of Scheduled Commercial Banks

Liabilities of Banks:
1. Capital and Reserves:

Together they constitute owned funds of banks. Capital represents paid-up capital, i.e., the
amount of share capital actually contributed by owners (shareholders) banks. Reserves are
retained earnings or undistributed profits of banks accumulated over their working lives. The law
requires that such reserves are built up and that not all the earned profits are distributed among
the shareholders. The banks also find it prudent to build up reserves to-improve their capital
position, so as to meet better unforeseen liabilities or unexpected losses. Reserves should be
distinguished from ‗provisions‘ made for redeeming known liabilities and affecting known
reductions in the value of certain assets.

2. Deposits:

At the present level of financial development in India, banks are the premier financial institution.
Deposit mobilisation by them remains the most important (though not the only) form of
mobilisation of savings of the public. Therefore, to the extent the promotion and mobilisation of
savings is a necessary prerequisite for stepping up the rate of economic growth, mobilisation by
banks in real terms must be given its due weight.

3. Borrowings:

Banks as a whole borrow from the RBI, the IDBI, the NABARD, and from the non-bank
financial institutions (the LIC, the UTI, the GIC and its subsidiaries, and the ICICI) that are
permitted to lend by the RBI in the inter-bank call money market. Individual banks borrow from
each other as well through the call money market and other-wise.

Assets of Banks:

Banks, like other business firms, are profit-making institutions, though public-sector banks are
also guided by broader social directives from the RBI. To earn a profit, a bank must place its
funds in earning assets, mainly loans and advances and investments. While lending or investing,
a bank must look at the net rate of return obtained and the associated risks of holding such
earning assets. Furthermore, since a large part of its liabilities are payable in cash on demand, a
bank must also consider the liquidity of its earning assets, that is, how easily it can convert its
earning assets into cash at short notice and without loss. Thus, the twin considerations of
profitability and liquidity guide a bank in the selection of its asset portfolio. A bank tries to
achieve the twin objectives by choosing a diversified and balanced asset portfolio in the light of
institutional facilities available to it for converting its earning assets into cash at short notice and
without loss and for short-term borrowing. In addition, it has also to observe various statutory
requirements regarding cash reserves, liquid assets, and loans and advances. We describe below
various classes of assets banks hold. They will also describe the uses of bank funds.

1. Cash: Cash, defined broadly, includes cash in hand and balances with other banks including
the RBI. Banks hold balances with the RBI as they are required statutorily to do so under the
cash reserve requirement. Such balances are called statutory or required reserves. Besides, banks
hold voluntarily extra cash to meet the day-to-day withdrawals of it by their depositors. Cash as
defined above is not the same thing as cash reserves of banks. The latter includes only cash in
hand with banks and their balances with the RBI only. The balances with other banks in
whatever account are not counted as cash reserves.

2. Money at Call at Short Notice:

It is money lent to other banks, stock brokers, and other financial institutions for a very short
period varying from 1 to 14 days. Banks place their surplus cash in such loans to earn some
interest without straining much their liquidity. If cash position continues to be comfortable, call
loans may be renewed day after day.

3. Investments:

They are investments in securities usually classified under three heads of (a) government
securities, (b) other approved securities and (c) other securities. Government securities are
securities of both the central and state government including treasury bills, treasury deposit
certificates, and postal obligations such as national plan certificates, national savings certificates,
etc. Other approved securities are securities approved under the provisions of the Banking
Regulation Act, 1949. They include securities of state- associated bodies such as electricity
boards, housing boards, etc., debentures of LDBs, units of the UTI, shares of RRBs, etc.

4. Loans, Advances and Bills Discounted-or Purchased

They are the principal component of bank assets and the main source of income of banks.
Collectively, they represent total ‗bank credit‘ (to the commercial sector). Nothing more need be
added here, bank advances in India are usually made in the form of cash credit and overdrafts.
Loans may be demand loans or term loans. They may be repayable in single or many
installments. We explain briefly these various forms of extending hank credit.

Credit Market Constraints : Another Principal Agent Problem

The relationship between the lender and the borrower is a principal–agent problem similar in
many ways to the relationship between the employer and employee studied in the previous unit.
The lender is the ‗principal‘ and the borrower is the ‗agent‘. The principal–agent problem
between borrower and lender is also similar to the ‗somebody else‘s money‘ problem. In that
case, the manager of a firm (the agent) makes decisions about the use of the funds supplied by
the firm‘s owners (the principals), but they cannot contractually require the manager to act in a
way that maximizes their wealth, rather than pursuing her own objectives.

One response of the lender to the conflict of interest in the credit market is to require the
borrower to put some of her wealth into the project (this is called equity). The more of the
borrower‘s own money that is invested in the project, the more closely aligned her interests are
with those of the lender. Another common response is to require the borrower to set aside
property that will be transferred to the lender if the loan is not repaid (this is called collateral).
Collateral is used in loans for houses (called mortgages) and for cars. For many people, these are
the only large loans they can get, and that is because of the collateral—the house, or the car
reverts to the lender if repayments are not made.

Credit rationing and inequality

credit rationing The process by which those with less wealth borrow on unfavourable terms,
compared to those with more wealth. Borrowers whose limited wealth makes it impossible to get
a loan at any interest rate are termed credit-excluded. Those who borrow, but only on
unfavourable terms, are termed credit-constrained. Both are sometimes said to be wealth-
constrained, meaning that their lack of wealth limits their credit market opportunities. credit-
excluded A description of individuals who are unable to borrow on any terms. credit-
constrained A description of individuals who are able to borrow only on unfavourable terms.
Figure shows Wealth, project quality, and credit. The exclusion of those without wealth from
credit markets or their borrowing on unfavourable terms is evident in these facts.

Inequality: Lenders Borrowers and Those Who Excluded From the

Credit Market
We can analyse inequalities between borrowers and lenders (and among borrowers) using the
Lorenz curve and Gini coefficient model that we used to study inequality among employers and
employees.

Lenders and borrowers in the Lorenz curve diagram

Here is an illustration. An economy is composed of 90 farmers who borrow from 10 lenders and
use the funds to finance the planting and tending of their crops. The harvest (on average) is sold
for an amount greater than the farmer‘s loan, so that for every euro borrowed and invested, the
farmer receives 1 + R when the crop is sold after the harvest. This is the farmer‘s revenue.
Following the harvest, the farmers repay the loans with interest, at rate i. To focus on the Lorenz
curve model, we simplify in this section by assuming that all of the loans are repaid and that all
lenders lend the same amount to the farmers at the same interest rate.

Thus, if i = 0.10 and R = 0.15, then the lender‘s share of total income is two-thirds and the
borrower‘s is one-third. Inequality in this economy is shown by the dark-shaded area bordered by
a solid line in Figure 9.16. The Gini coefficient is 0.57.
A model economy of lenders and borrowers

An economy is composed of 90 farmers who borrow from 10 lenders. since i=0.10 and Profit is
0.15, the lenders share of total income is 2/3 and the borrowers is 1/3 the gini coefficient is 0.57.
This example illustrates the fact that inequality in the economy is that some people are in a
position to profit by lending money to others. It is true that in determining the rate of interest at
which an individual will borrow, because lenders superior borrowing power.

But do banks and financial system make some people poor, and other people rich. Banks are
institutions to make profit owned by wealthy people. Banks credit and money are essential to a
modern economy. Because they provide economic opportunities for all citizen through
borrowing and lending power.