Financing of Banks

“We can think of a bank’s liabilities as the sources of its funds, and we can think of a bank’s assets as the uses of its funds.”

The above statement implies that bank liabilities are the means that banks use to source their funds. The sources of fund for an organization include deposits, borrowed capital, and shareholder funds. Deposits from customers is the largest source of fund for banks. The deposits represent the money that account holders entrust to the banks for safekeeping and for use in the future. banks charge a fee for the safekeeping referred to as interest. The money belongs to the customers and thus a liability to the bank and customers have a right to make withdrawals from their accounts. Another source of funds to banks is issuing of debts.  While it provides funds to the bank, this is a form of liability to the bank. Shareholders’ capital is another source of funds to the banks that is long-term in nature and can only be returned upon liquidation of the bank. 

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The assets of a bank include loans it gives to its customers and securities provided for such loans which represents the uses of the bank’s funds. Banks generates income from providing loans to customers at higher rates that interest for the deposits. This implies that the loans issued to customers are the sources of incomes to the bank and thereby considered as assets. 

Leverage of Banks

Managers of highly leveraged banks understand and are eager to utilize the tax-shield benefits associated with debt in the effort of raising the value of the firm. It is also clear to such managers that when in need to extra funds, debts are easier to acquire in comparison to equity. The managers would also want to utilize the fact that the interests on debt are in most cases known making forecasting and planning easier. Sourcing capital from debts especially in times on economic boom and taking precautions against excessive leverage assures the managers of such banks of benefits associated with debt financing. It can be noted that debt has an advantage due its informational insensitivity property such as immediacy, safety, and ease in valuation that appears attractive to such managers (DeAngelo & Stulz, 2013). Another reason why managers may prefer high leverage is to improve the performance of the bank int terms of a higher ROE since this is a major determinant of their earnings in form of bonus.

Shareholders of banks on the other hand, would prefer to have the banks less highly leveraged. To most shareholders, the investments in banks is long term venture and would thus prefer banks to have less leverage which is associated with less risks. This protects their investment and returns from the investment in the banks. 

ReferenceDeAngelo, H., & Stulz, R. M. (2013). Why high leverage is optimal for banks (No. w19139). National Bureau of Economic Research.

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