Notes on Bank’s Balance Sheet and Portfolio Management

Conventionally, banks publish balance sheets in their annual reports. The balance sheet contains particulars of a bank’s current assets and current liabilities. Assets items refer to all credit items in indicating the wealth and claims possessed by the bank.

Liability items refer to all debit items indicating the obligations of the bank. Thus, the balance sheet indicates the manner in which the bank has raised funds and invested them in various types of assets.

It is the means by which the banks financial position its solvency and liquidity is judged. There is, of course, the equity of assets and liabilities in the balance sheet of a bank, as in the case of any other balance sheet.

In a balance sheet, it is customary to state the liabilities on the left and assets on the right. The liabilities of the bank are the items which are to be paid by it either to its shareholders or depositors.

The assets of the bank are those items from which it hopes to get an income. Thus, the assets include all the amounts owed by others to the bank.

Objectives of Portfolio Management:

A commercial bank has to manage its assets and liabilities with three considerations in mind, namely, liquidity, profitability, and solvency.

Liquidity means the capacity of the bank to give cash on demand in exchange for deposits. But since a bank is a commercial concern, it aims at profitability. Profits come from the income accruing from the assets the bank holds.

The banker must arrange his assets in such a way that he makes more income. Hence, in acquiring assets, the banker will be influenced by the consideration of profit. A bank acquires assets mainly out of the deposits of the public.

The working of the bank, its survival and continued existence will, therefore, depend upon the depositing public. Public confidence in the bank, however, depends on the belief that the bank will always be able to exchange deposits for cash.

A bank, therefore, must keep a sufficient amount of cash balance to meet the actual demand, while for meeting the potential demand; it has to keep its assets sufficiently liquid.

Cash has perfect liquidity, but yields no return at all, while other income-yielding assets such as loans are profitable but have no liquidity. Liquidity and profitability are, therefore, conflicting considerations for the bankers.

Another consideration of the bank is its own solvency and security; this refers to the liquidity and shift-ability of assets. Liquidity is the capacity to produce cash on demand. Shift-ability means that type of assets acquired by a bank should be easily shift-able to other banks or to the central bank.

Therefore, a banker will prefer securities which can be quickly disposed of and which are easily shift-able without any loss to the bank or to those which are highly risky but more profitable.

In this connection, Prof. Meyers draws a clear-cut distinction between the terms “solvency” and “liquidity.” A bank is solvent if the amount of its assets exceeds the amount of its liabilities to all claimants other than its shareholders.

But a bank is liquid only to the extent that it can turn its assets into cash to meet the demands of depositors and other creditors. Hence, many a times, a bank which is solvent may not be liquid.

Its assets may exceed its liabilities, but the assets may not be in such a form that they are readily convertible into cash. When a bank’s assets are largely in the form of real estate mortgages or in the form of claims which are not easily saleable, the bank is said to possess frozen assets.

Thus, the two motives of a bank’s liquidity and profitability are contradictory, but have to be reconciled. A good banker is one who follows a wise investment policy and distributes the assets in such a way that both the requirements of liquidity and profitability are satisfied.

The assets should bring in maximum profits and should provide maximum security to the depositors. The secret of success of a bank lies in striking a sound balance between liquidity and profitability.

Thus, as Meyers puts, “A constant tug of war between the competing aims of liquidity and profitability summarises the functions of a modern bank.”

In reading a balance sheet of a bank, we have to examine the liabilities and assets portfolios which reveal how best the two objectives of liquidity and profitability have been reconciled by the banker.

Liabilities Portfolio:

The liabilities portfolio of a bank is comparatively simple. It shows how the bank raises funds. Every commercial bank usually gets its funds in three ways: by share capital, reserve fund and deposits from the general public.

1. Share capital is the contribution made by the shareholders of the bank. The amount of share capital is the bank’s liabilities of its shareholders.

2. Reserve fund is the amount accumulated over years out of undistributed profits intended for contingencies. This is also a part of the liabilities toward shareholders.

3. Deposits from the public constitute the biggest proportion of the bank’s working funds. Deposits are accepted by the bank in current, fixed, and savings accounts; accordingly, they are categorised as demand, time, and saving deposits.

These funds are the liabilities of the bank to their customers, which have to be returned to them. But, at the same time, these funds are also assets to the bank since the banker can make use of them to get certain interest yielding assets.

4. Liabilities are also created when banks borrow from other banks on a temporary basis.

5. Finally, miscellaneous liabilities are incurred by the bank in the course of its business. For instance, liabilities may be incurred by accepting or endorsing bills of exchange on behalf of customers.

This means that when the bank has accepted or endorsed bills for its customers, it is technically liable to meet them on maturity, but since the customers are expected to meet them and have presumably given due security, this liquidity to the customer of the bank is an offsetting asset against the acceptance.

Assets Portfolio:

The assets portfolio of the bank is both complex and interesting. It represents more faithfully the varied nature and ramifications of the bank’s functions and investment policies.

In fact the assets side of the balance sheet indicates the manner in which the funds entrusted to the bank are deployed.

Usually, every banker seems to arrange its assets in an ascending order of profitability and descending order of liquidity. Thus, the structure of a balance sheet indicates assets appearing in the descending order of liquidity.

Generally, the assets side comprises the following items:

1. Cash:

The first item on the assets side is cash which a bank holds in its till in order to meet the routine needs of day-to-day withdrawals of deposits by customers. Of course, the balance so held need only be a very small proportion of the total deposits.

This is called cash reserve. From its experience a bank knows how much cash reserve will have, to be kept to meet the demands of depositors. Cash reserves may also consist of cash held either with other commercial banks or with the central bank.

Generally, nine per cent to eleven per cent of the total deposits is kept as cash reserve. The actual cash reserve ratio varies from country to country, depending upon many factors. Cash has perfect liquidity, but yields no profit.

2. Money at call and short notice:

This mainly pertains to short-term loans to the money market. Speculators in stock exchange markets borrow such loans.

Such loans can be called back for the immediate requirement by the bank at a very short notice of say one day to seven days. Thus, these forms of assets are highly liquid and are interest earning, too, though at a comparatively low rate.

3. Bills discounted:

Banks invest a considerable part of their funds in commercial bills which are short- dated, usually for three months. Banks may also discount treasury bills. They prefer these assets because they are self-liquidating in character, that is, they become liquid as they mature.

4. Investments:

Commercial banks mainly invest in government securities, shares, etc. Generally, banks prefer short-term or medium-term securities.

These investments are highly shift-able and income-yielding. In fact, securities and bonds are also called the bank’s secondary reserves because they are shift-able.

This secondary reserve fails to act as a true reserve if all the banks in the country attempt to convert securities into cash at the same time.

In this connection, F.A. Bradford says that, from the point of view of the banking system, the transfer of assets from one bank to another does not represent liquidation, for the system itself is still carrying the assets.

The assets which can be transferred readily from one bank to another have the characteristics of shift-ability, while assets that can be liquidated outside the banking system are really liquid.

5. Advances:

The bank’s loans and advances to its customers are the most profitable assets of the bank. The profitability of a bank depends upon the extent to which it grants loans or advances to customers.

But, from the point of view of safety and its liquidity, loans and advances are poor assets. But here also, liquidity is not totally neglected.

Banks usually grant short-term working capital loans only so that they can have fair liquidity together with high profitability.

6. Other items:

Under this head, liabilities of customers on acceptance among other things are recorded, which is also represented on the side of liabilities by a similar account and thus balanced.