AP Syllabus focus: ‘Depository institutions organize assets and liabilities on balance sheets and operate under fractional reserve banking.’
Banks are financial intermediaries that transform deposits into loans and other earning assets. To understand how they operate and how they create money-like deposits, you must read a bank’s balance sheet.
Bank balance sheets: what they show
A bank’s balance sheet is a snapshot of what the bank owns and owes, plus the owners’ claim.
A stylized bank balance sheet (T-account) showing assets on the left and liabilities/net worth on the right. In this example, the bank’s asset is reserves and the matching liability is deposits, illustrating that the balance sheet must balance at every moment. This is the basic accounting framework used to track how later actions (like lending) change bank assets and deposit liabilities. Source
Balance sheet: A financial statement listing an institution’s assets (uses of funds) and liabilities plus equity (sources of funds) at a point in time.
A key implication is that a bank is not “holding everyone’s money in a vault.” Instead, it holds a mix of liquid assets and longer-term, higher-return assets while promising depositors access to funds.
= What the bank owns (dollars)
= What the bank owes others (dollars)
= Owners’ claim / net worth (dollars)
This identity always holds: every dollar of assets is financed by either borrowing (liabilities) or owners’ funds (equity).
Assets (uses of funds)
Common bank assets include:
Reserves: highly liquid funds available to meet withdrawals and payments
Loans: mortgages, business loans, consumer credit (typically less liquid, higher return, higher risk)
Securities: holdings such as government bonds (often more liquid than loans, usually lower risk than many private loans)
Reserves: The most liquid bank assets used to settle payments and meet depositor withdrawals; commonly include cash held by the bank and deposits held at the central bank.
Asset choice reflects trade-offs between liquidity, return, and risk. A more loan-heavy portfolio may raise expected interest income but can increase default risk and reduce liquidity.
Liabilities (sources of funds)
Common bank liabilities include:
Deposits (especially checking/demand deposits): money the public can spend or withdraw
Borrowing: funds borrowed from other banks or financial institutions
Deposits are liabilities because they are promises to pay: the depositor can demand cash or transfer funds to someone else, so the bank owes that amount.
Equity (bank capital)
Equity (often called capital) is the buffer that absorbs losses. If some loans default, asset values fall; equity falls first before depositors take losses (in simplified accounting terms). A better-capitalised bank is generally safer and more able to withstand shocks.
Fractional reserve banking: the core idea
Banks operate under fractional reserve banking, meaning they keep only a fraction of deposits as reserves and use the rest to acquire earning assets like loans and securities.
Fractional reserve banking: A banking system in which depository institutions hold reserves equal to only a portion of deposit liabilities and lend or invest the remainder.
Why hold only a fraction?
Banks can do this because:
Not all depositors withdraw funds at the same time (predictable net flows)
Payment systems allow many transactions to be settled without physical cash
Banks manage liquidity with reserves and other liquid assets
Link to deposit (money) creation
When a bank makes a loan, it typically credits a borrower’s deposit account, increasing deposit balances. Those deposits function as spendable money for households and firms. This mechanism is central to how the banking system supports the wider economy, but it also means banks must carefully manage liquidity and risk so they can meet withdrawals and payment obligations.
FAQ
Equity is owners’ funding (net worth) that absorbs losses.
Reserves are liquid assets used for payments and withdrawals. A bank can have high reserves but low equity, or vice versa, because they serve different purposes.
Deposits can be a relatively stable and low-cost source of funds.
However, they are “runnable” if confidence falls, so banks also manage liquidity and diversify funding to reduce reliance on any single source.
Banks often fund long-term assets (like mortgages) with short-term liabilities (like demand deposits).
This can raise profitability but increases liquidity risk, because liabilities can come due before assets can be easily sold.
When expected loan repayment falls, the value of loan assets is written down.
That reduces assets; the balancing reduction typically comes through lower equity, since liabilities to depositors do not automatically shrink.
Securities may be more liquid and easier to value than many loans.
They can help the bank manage risk, meet liquidity needs, and earn a return without taking on the underwriting and monitoring costs of additional lending.
Practice Questions
(3 marks) Explain why customer deposits are recorded as a liability on a commercial bank’s balance sheet.
States that deposits are funds the bank owes to customers / a claim customers have on the bank (1)
Explains that customers can withdraw or transfer deposits on demand, creating an obligation to pay (1)
Connects to the balance sheet identity: liabilities finance assets / must be matched by assets and equity (1)
(6 marks) A bank receives new deposits and chooses to keep only a fraction as reserves. Using balance sheet logic, explain how fractional reserve banking allows banks to hold reserves and also hold loans or securities.
Defines fractional reserve banking as holding reserves equal to only a portion of deposits (1)
Identifies deposits as a liability and reserves/loans/securities as assets (1)
Explains that new deposits increase the bank’s liabilities and typically increase assets (e.g., reserves initially) (1)
Explains the bank can reallocate assets: keep some as reserves for liquidity and use the remainder to acquire loans/securities for return (2)
References that the balance sheet must balance (assets financed by liabilities and equity) throughout the process (1)
