THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 355
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CHAPTER 13
Banking and the Management of Financial Institutions
323
When it suffers the $10 million deposit outflow, its balance sheet becomes
Assets
Reserves
Loans
Securities
Liabilities
$ 0 million
$90 million
$10 million
Deposits
Bank capital
$90 million
$10 million
After $10 million has been withdrawn from deposits and hence reserves, the bank
has a problem: its desired reserves are 10% of $90 million, or $9 million, but it has
no reserves! To eliminate this shortfall, the bank has four basic options. One is to
acquire reserves to meet a deposit outflow by borrowing them from other banks
in the overnight market or by borrowing from corporations.1 If the First Bank
acquires the $9 million shortfall in reserves by borrowing it from other banks or
corporations, its balance sheet becomes
Assets
Reserves
Loans
Securities
Liabilities
$ 9 million
$90 million
$10 million
Deposits
Borrowings
from other
banks or
corporations
Bank capital
$90 million
$ 9 million
$10 million
The cost of this activity is the interest rate on these loans, such as the overnight
interest rate.
A second alternative is for the bank to sell some of its securities to help cover
the deposit outflow. For example, it might sell $9 million of its securities and deposit
the proceeds with the Bank of Canada, resulting in the following balance sheet:
Assets
Reserves
Loans
Securities
Liabilities
$ 9 million
$90 million
$ 1 million
Deposits
Bank capital
$90 million
$10 million
The bank incurs some brokerage and other transaction costs when it sells these
securities. The government of Canada securities that the bank holds are very liquid, so the transaction costs of selling them are quite modest. However, the other
securities the bank holds are less liquid, and the transaction costs can be appreciably higher.
1
One way that the First Bank can borrow from other banks and corporations is by selling negotiable certificates of deposit. This method for obtaining funds is discussed in the section on liability management.
