326 PA R T I V The Management of Financial Institutions banks were not well developed, banks rarely borrowed from other banks to meet their reserve needs Starting in the 1960s, however, large banks (called money centre banks) began to explore ways in which the liabilities on their balance sheets could provide them with reserves and liquidity This led to an expansion of overnight loan markets, such as the federal funds market in the United States and the overnight funds market in Canada, and the development of new financial instruments such as negotiable CDs (first developed in 1961), which enabled money centre banks to acquire funds quickly.2 This new flexibility in liability management meant that banks could take a different approach to bank management They no longer needed to depend on chequable deposits as the primary source of bank funds and as a result no longer treated their sources of funds (liabilities) as given Instead, they aggressively set target goals for their asset growth and tried to acquire funds (by issuing liabilities) as they were needed For example, today, when a money centre bank finds an attractive loan opportunity, it can acquire funds by selling a negotiable CD Or if it has a reserve shortfall, funds can be borrowed from another bank in the overnight market without incurring high transaction costs The overnight market can also be used to finance loans Because of the increased importance of liability management, most banks now manage both sides of the balance sheet together in an asset liability management (ALM) committee The emphasis on liability management explains some of the important changes over the past three 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, chequable deposits have decreased in importance Newfound flexibility in liability management and the search for higher profits have also stimulated banks to increase the proportion of their assets held in loans, which earn higher income Capital Adequacy Management Banks have to make decisions about the amount of capital they need to hold for three reasons First, bank capital helps prevent bank failure, a situation in which the bank cannot satisfy its obligations 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 Third, a minimum amount of bank capital (bank capital requirements) is required by regulatory authorities Let s consider two banks with identical balance sheets, except that the High Capital Bank has a ratio of capital to assets of 10% while the Low Capital Bank has a ratio of 4% HOW BANK CAPITAL HELPS PREVENT BANK FAILURE High Capital Bank Assets Low Capital Bank Liabilities Reserves $10 million Loans $90 million Deposits Bank capital $90 million $10 million Assets Reserves $10 million Loans $90 million Liabilities Deposits Bank capital $96 million $ million Because small banks are not as well known as money centre banks and so might be a higher credit risk, they find it harder to raise funds in the negotiable CD market Hence, they not engage nearly as actively in liability management