THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 349

CHAPTER 13

Banking and the Management of Financial Institutions

317

is a cushion against a drop in the value of its assets, which could force the bank
into insolvency (having liabilities in excess of assets, meaning that the bank can
be forced into liquidation).

Assets

A bank uses the funds that it has acquired by issuing liabilities to purchase incomeearning assets. Bank assets are thus naturally referred to as uses of funds, and the
interest payments earned on them are what enable banks to make profits.
All banks hold some of the funds they acquire as deposits in an
account at the Bank of Canada, in the form of settlement balances. Reserves are
these settlement balances plus currency that is physically held by banks (called
vault cash because it is stored in bank vaults overnight). Although Canadian
banks are not required to hold reserves in some proportion to their deposits
(Canada removed all such legal requirements in June 1994) and there is a requirement of zero settlement balances with the Bank of Canada at the end of each banking day, banks hold some reserves, which we call desired reserves.
Banks hold reserves because of their desire to manage their own short-term
liquidity requirements and respond to predictable clearing drains and predictable
across-the-counter and automated banking machine drains. Moreover, banks hold
reserves in order to meet unpredictable and potentially large withdrawals by their
liability holders. The risk that net cash withdrawals might be negative is known
as banker s risk, and from the perspective of this risk, banks hold reserves to
meet unpredictable cash and clearing drains. We will refer to the fraction of
deposits banks hold in the form of reserves as the desired reserve ratio.

RESERVES

Suppose that a cheque written on
an account at another bank is deposited in your bank and the funds for this
cheque have not yet been received (collected) from the other bank. The cheque
is classified as a cash item in process of collection, and it is an asset for your bank
because it is a claim on another bank for funds that will be paid within a few days.
Items in process of collection are also called items in transit or bank float.

CASH ITEMS IN PROCESS OF COLLECTION

Many small banks hold deposits in larger banks in
exchange for a variety of services, including cheque collection, foreign exchange
transactions, and help with securities purchases. These deposits are known as
interbank deposits.
Collectively, reserves, cash items in process of collection, and deposits at other
banks are referred to as cash items. In Table 13-1 they constitute close to 5% of
total assets, and their importance has been shrinking over time: in 1960, for example, they accounted for over 20% of total assets.

DEPOSITS AT OTHER BANKS

A bank s holdings of securities are an important income-earning
asset: securities (made up entirely of debt instruments for commercial banks
because banks are not allowed to hold stock) account for more than 23% of bank
assets in Table 13-1. These securities can be classified into three categories: government of Canada, provincial and municipal securities, and other securities. The
government of Canada securities are the most liquid because they can be easily
traded and converted into cash with low transaction costs. Because of their high
liquidity, short-term Canadian government securities (such as treasury bills) are
called secondary reserves.
Provincial and municipal government securities are desirable for banks to hold
primarily because provincial and municipal governments are more likely to do

SECURITIES