Most of the services offered by a bank are largely financial in nature. However, the terms Assets and Liabilities have a different meaning when it comes to banks. For instance, assets in banking terminology would indicate fund usage, while liabilities in case of banks would, in fact, be a source of funds for banks. This essay will consider five different services or function that a bank offers and would explain with reasons if the said service is an asset or a liability, while also evaluating the services and providing an overall impression of the same.
This essay considers the services offered by Wells Fargo bank. However, most banks offer services that are almost similar in nature with very little to no differences between the offered services. The bank offers Bonds, Repurchase Agreements, Savings Deposits, Transaction Deposits and Bank Loans amongst some of its services. (Wells Fargo, 2016) This essay will primarily consider these five services and ignore the fee based services that the bank provides its clients from time to time.
Bonds Issued by the Bank
Wells Fargo issues bonds in the category of Corporate Bonds from time to time. These bonds have a credit rating of A. They are of varying maturities and range from Floating Interest Rates to Fixed Interest rates with coupons varying from 2.5% to 5.625% (Morningstar, 2016).
Since these bonds are instruments for fund raising used by the bank to fund their operations, these would be slotted under Liabilities. In effect, the bank borrows money from the markets through bond issuances and at some point in time these funds need to be returned back to the investors with an interest cost attached to it. Thus, these bonds become liabilities of the bank.
Repurchase Agreements
Repurchase agreements are also called Repos. A repo is the sale of a security with a simultaneous commitment by the seller to repurchase the security from the buyer at a future date at a predetermined price. A repo typically allows a selling party to obtain financing from the buying party. In this case, the security is held as collateral that protects the buyer against a default risk from the seller. A default in this case would occur when the seller is unable to repurchase the security as agreed. Therefore, a repurchase agreement or a repo transaction may be thought of as a collateralized loan to the seller of the repo. (Wells Fargo, 2016)
Since repo transactions typically occur between two financial institutions the recognition of these transactions is not very straightforward. For purposes of this paper, we consider the sell-and-buyback type of repo. In this case, a repo transaction is structured like a sale, with possession of a security changing hands during its term, the normal accounting treatment as per the International Financial Reporting Standards (IFRS) require that securities on repo are reclassified from “investments” to “collateral” and are balanced by a “collateralised borrowing” liability. The opposite would also be true and is termed as reverse repo. Thus, repos could be either assets or liabilities depending on whether the bank is performing a repo or reverse repo. If the bank sells a particular security to another bank it receives funds and, in return, gives a commitment to repurchase the same security after a certain period of time. In such a case, the repo becomes a liability. If the bank buys the same security and lends cash instead, it would recognize the repo as an asset.
Savings Deposits
These deposits are examples of non-transaction deposits. Some banks also call them as Certificate of Deposits (CDs). The bank pays an interest rate to the depositor for keeping funds in these instruments. Since these deposits do not see frequent transactions and a penalty is applicable for premature withdrawal, these are categorized as non-transaction deposits. Further, there are two types of CD’s – a retail one and a Large CD. The retail CD is mostly under $100,000, while the Large CDs are over that amount and are negotiable as well as tradable as opposed to retail CDs.
Since money kept in a CD has to be ultimately returned back to the depositor along with the applicable interest, Savings Deposits are Liabilities to the bank, and, in essence, are an important source of funds for the bank. The interest rates that a bank offers on CDs depends on the duration as well as the banks own rating. For instance, short term deposits have a lower rate of interest as compared to those with a five year duration. (Wells Fargo, 2016) Likewise, deposits offered by Credit Unions have a higher rate of interest as compared to banks. The maxim of higher the risk, higher the return becomes applicable in this case (however between comparable banks differences in interest rates do not necessarily mean one institution is riskier than the other). Thus, an interest rate offered by the bank tells us also of the bank’s debt quality as well as its assigned ratings.
Transaction Deposits
As opposed to savings deposits, Transaction Deposits are also called Checkable Deposits. The US Federal Reserve (2016) defines transaction deposits and other similar accounts that can be used directly as cash without withdrawal limits or restrictions. (US Fed, 2016)
Transaction accounts are the only type of accounts for which the US Fed requires banks to maintain reserves at the central bank. The reason for this is that these deposits have full liquidity with no waiting time for fund withdrawal. From this particular aspect, one can understand that these deposits have to be given the same treatment as a CD and also form a liability on the part of the bank since eventually these deposits are withdrawn from the bank by depositors.
Bank Loans
The very mention of a bank loan brings to mind the notion that a bank loan is a liability, which is not true. For the individual or corporation that raises the bank loan it most certainly is a liability since it is required to be paid back. However, the same is not the case with a bank.
When a bank loans money to a borrower, it charges an interest rate to the borrower, thus making money on the transaction. For the bank, the money raised from deposits are used for borrowing. Thus, the loans become a mode for the using the funds and, thus, an asset. In doing so, the bank always ensures that the interest rate charged on a loan is always high enough to cover the cost of the liabilities (deposits + bonds), while keeping a profit over and above the liability. These factors determine the interest rate that a bank charges a borrower. The interest rates would also fluctuate depending on the credit history of the borrower as well as the risk that the bank perceives in lending to a certain borrower. Thus, in all of these cases, bank loans would always be recognized as assets.
Evaluation of Banking Services
If one examines these services as a part of a system, one sees the inherent logic in the specific design of each of these services. A bank raises money through issuances of corporate bonds, repurchase agreements (repo), maintaining savings deposits as well as transaction deposits – all of which are recognized as liabilities. On the other hand, the bank applies these funds to make profits by either loaning out the money or entering into certain repurchase agreements (reverse repo) with other financial institutions it would be an asset. At the end of the day, the bank must ensure that it maximizes the use of its funds, while keeping the cost of funds down and the interest rate on assets high in order to remain profitable.
In conclusion, my overall impression is that this whole system runs like a well-oiled machine complete with a formidable regulator in the form of the Federal Reserve that makes the banking system function as the backbone of the economy. I feel that this whole thing looks extremely interesting and of great interest.
Reference
Wells Fargo Bank. (2016). Personal and Business Banking. Retrieved from https://www.wellsfargo.com
Quick Take – Wells Fargo & Co. (2016). Wells Fargo Bonds data. Morningstar. Retrieved from http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=wfc
US Federal Reserve. [US Fed] (2016). Assets and Liabilities of Commercial Banks in the United States. Retrieved from http://www.federalreserve.gov/releases/h8/20160513/
