THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 346

CHAPTER 13 Banking and the Management of Financial Institutions LE A RNI NG OB J ECTI VES After studying this chapter you should be able to outline a bank s sources and uses of funds specify how banks make profits by accepting deposits and making loans discuss how bank managers manage credit risk and interest-rate risk explain gap analysis and duration analysis illustrate how off-balance-sheet activities affect bank profits PRE VI EW Because banking plays such a major role in channelling funds to borrowers with productive investment opportunities, this financial activity is important in ensuring that the financial system and the economy run smoothly and efficiently In Canada and other countries, banks (depository institutions) provide loans to businesses, help us finance our postsecondary educations or the purchase of a new car or home, and provide us with services such as chequing and savings accounts Managing banks, however, has never been an easy task, and recently it has become even more difficult because of greater complexity and uncertainty in the economic environment Asset prices and interest rates have become much more volatile, resulting in substantial fluctuations in profits and in the value of assets and liabilities held by financial institutions In this chapter, we examine how banking is conducted to earn the highest profits possible, how and why banks make loans, how they acquire funds and manage their assets and liabilities (debts), and how they earn income We also examine how banks cope with credit risk, the risk arising because borrowers may default on their obligations, and with interest-rate risk, the risk arising from fluctuations in interest rates Although we focus on commercial banking, because this is the most important financial intermediary activity, many of the same principles are applicable to other types of financial intermediation THE BAN K BA LAN CE S HEE T To understand how banking works, we start by looking at the bank balance sheet, a list of the bank s assets and liabilities As the name implies, this list balances; that is, it has the characteristic that Total assets 314 total liabilities capital