A Law and Finance Approach
Appendix: A case study
To illustrate bank funding dynamics, this case study traces the balance sheet transformations of a hypothetical commercial bank – Acme – as it faces two routine funding challenges. First, the bank’s survival as a going concern turns on its money position. Second, the bank must also contend with threats to funding stability over the medium term caused by the maturing of large liabilities.Assume that Acme has common and preferred stock paying a quarterly dividend and some undivided profits from previous operations. This comprises the totality of Acme’s equity capital. Acme could do little if it used only owners’ capital. To increase the scale of its own investments, the bank borrows.Acme has two kinds of deposits: retail deposits and brokered deposits. These deposits present some liquidity risk because if Acme’s depositors decided to withdraw their deposits, the bank would have to come up with funds on very short notice to honor their withdrawal requests. Though deposit insurance makes a run on retail deposits unlikely, Acme must set aside some cash as a reserve against the risk of withdrawal by a depositor. Acme divides this reserve into vault cash and its reserve deposit at the Federal Reserve. Because Acme seeks yield by keeping its low-rate liquid assets to a minimum, its existing reserves do not meet the minimum reserve requirement established by federal law. To cover the deficit, Acme buys reserves from a commercial bank that has excess reserves, called federal funds. Like the retail deposits, this purchase of reserves is a liability because...
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