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
1. outline a bank s sources and uses of funds
2. specify how banks make profits by accepting deposits and making loans
3. discuss how bank managers manage credit risk and interest-rate risk
4. explain gap analysis and duration analysis
5. 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