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manage both sides of the balance sheet together in a so-called asset–liability management
(ALM) committee.
The emphasis on liability management explains some of the important changes
over the pastthree decades in the composition of banks’ balance sheets. While negotiable
CDs and bank borrowings have greatly increased in importance as a source of
bank funds in recent years (rising from 2% ofbank liabilities in 1960 to 42% by the
end of 2002), checkable deposits have decreased in importance (from 61% of bank
liabilities in 1960 to 9% in 2002). Newfound flexibility in liabilitymanagement and
the search for higher profits have also stimulated banks to increase the proportion of
their assets held in loans, which earn higher income (from 46% of bank assets in 1960
to 64% in 2002).Banks have to make decisions about the amount of capital they need to hold for three
reasons. First, bank capital helps prevents bank failure, a situation in which the bank
cannot satisfy itsobligations to pay its depositors and other creditors and so goes out
of business. Second, the amount of capital affects returns for the owners (equity holders)
of the bank. And third, a minimum amountof bank capital (bank capital
requirements) is required by regulatory authorities.
How Bank Capital Helps Prevent Bank Failure. Let’s consider two banks with identical
balance sheets, except thatthe High Capital Bank has a ratio of capital to assets of
10% while the Low Capital Bank has a ratio of 4%.
Suppose that both banks get caught up in the euphoria of the telecom market,
only to findthat $5 million of their telecom loans became worthless later. When
these bad loans are written off (valued at zero), the total value of assets declines by
$5 million, and so bank capital, whichequals total assets minus liabilities, also
declines by $5 million. The balance sheets of the two banks now look like this:
Capital Adequacy
C H A P T E R 9 Banking and the Management of...