AQA Specification focus:
‘The structure of a commercial bank’s balance sheet.’
Commercial banks play a vital role in the economy, and their balance sheets reveal how they manage assets, liabilities, and capital to achieve stability and profitability.
Overview of a Commercial Bank Balance Sheet
A balance sheet is a financial statement that summarises a bank’s financial position at a specific point in time. It lists assets (what the bank owns or is owed) and liabilities (what the bank owes), with the difference representing shareholders’ equity or capital.
The structure of a commercial bank’s balance sheet reflects its dual role of safeguarding deposits and generating profits through lending and investment. Unlike firms in other industries, banks must constantly balance liquidity, profitability, and security while meeting regulatory requirements.
Main Components of a Commercial Bank Balance Sheet
Assets
Assets represent how a bank uses its funds. They are usually divided into liquid and less-liquid categories.
Cash and reserves:
Cash held at the central bank or in the vaults to meet immediate withdrawals. These are highly liquid but earn little or no return.Loans and advances:
Money lent to households, firms, and governments. Loans are less liquid but are the main source of bank income via interest payments.Investments:
Holdings of government bonds, corporate bonds, or other securities. These can provide returns but carry risk if bond prices fall.Fixed assets:
Buildings, technology, and equipment. These are long-term and non-liquid, but essential for operations.
Asset: A resource owned or controlled by a bank that is expected to generate future economic benefit.
Liabilities
Liabilities show how banks fund their activities. They are mostly short-term, reflecting the public’s deposits.
Customer deposits:
Current accounts, savings accounts, and term deposits. These are the largest liability and form the foundation of banking activity.Borrowings:
Funds borrowed from other banks, the central bank, or international markets. Used to manage liquidity or expand lending.Debt securities issued:
Bonds or notes sold to investors to raise finance.
Liability: A financial obligation or debt that a bank must settle in the future, typically by transferring money or services.
Shareholders’ Equity (Capital)
This is the residual claim once assets have been used to settle liabilities. It represents the bank’s own funds, providing a cushion against unexpected losses.
Paid-in capital: Money from shareholders in exchange for shares.
Retained earnings: Profits reinvested instead of paid out as dividends.
Equity is crucial for financial stability since it absorbs shocks, protecting depositors and creditors.
Liquidity vs Profitability in the Balance Sheet
Commercial banks face a constant tension between holding liquid assets for security and using funds for profitable activities.
Liquid assets (cash, central bank reserves) ensure customers can withdraw deposits.
Illiquid assets (long-term loans, mortgages) generate higher returns but cannot be quickly converted into cash.
The balance sheet must reflect a strategy that avoids both excessive risk and inadequate profitability.
Risk Management and Balance Sheet Structure
Maturity Transformation
Banks borrow short-term (through deposits) but lend long-term (through mortgages and loans). This mismatch generates profit but also risk if many depositors demand funds simultaneously.
Maturity mismatch: The risk that arises when a bank’s liabilities are predominantly short-term while its assets are long-term and less liquid.
Capital Adequacy
Regulators require banks to maintain minimum levels of capital ratios to ensure solvency. Strong capital positions improve confidence and reduce the risk of failure.
Liquidity Ratios
Balance sheets are examined to check if banks hold sufficient liquid assets to meet sudden demands for withdrawal or market stress.
Balance Sheet as a Reflection of Bank Objectives
The structure of a balance sheet directly reflects a bank’s objectives:
Liquidity: Ensured through cash, reserves, and highly tradable securities.
Profitability: Driven by loans and investments.
Security: Achieved through strong capital buffers and diversified assets.
These objectives often conflict. For example, holding more liquid assets increases safety but reduces profitability, while lending aggressively may improve profits but increase risk.
Summary of Key Points in Balance Sheet Structure
Assets: Cash, loans, investments, fixed assets.
Liabilities: Deposits, borrowings, debt securities.
Equity: Paid-in capital and retained earnings.
Risks: Maturity mismatch, insufficient capital, liquidity shortages.
Objectives balance: Liquidity, profitability, and security guide how the balance sheet is structured.
FAQ
Deposits provide banks with a large, relatively cheap source of funding, forming the backbone of lending activities.
However, deposits are also volatile liabilities. If depositors lose confidence and withdraw funds quickly, banks can face liquidity crises, even when their assets remain profitable but illiquid.
Central banks often require banks to hold a minimum proportion of deposits as reserves.
These reserves appear as assets on the balance sheet but cannot be lent out, limiting profitability.
Higher requirements increase safety and liquidity, while lower requirements allow banks to expand lending but raise systemic risk.
Government bonds are highly liquid and carry low default risk, making them an ideal asset for meeting sudden cash needs.
They also generate interest income, albeit at lower rates than riskier loans. Their dual role of safety and return supports liquidity management and balance sheet stability.
Retained earnings add to shareholders’ equity, increasing the bank’s capital base.
A higher capital base allows banks to absorb unexpected losses.
Stronger equity positions reassure regulators and investors, enabling banks to expand lending without breaching capital adequacy rules.
The balance sheet typically shows short-term liabilities (like deposits) alongside long-term assets (like mortgages).
This mismatch creates profit opportunities but exposes banks to liquidity pressures if too many depositors demand withdrawals before loans are repaid.
Effective balance sheet management involves monitoring asset maturity profiles and maintaining sufficient liquid reserves.
Practice Questions
Identify two items that would typically appear on the liabilities side of a commercial bank’s balance sheet. (2 marks)
1 mark for each correct item identified (maximum 2 marks).
Acceptable answers include:
Customer deposits
Borrowings from other banks or the central bank
Debt securities issued
Explain how the balance sheet of a commercial bank reflects the conflict between liquidity and profitability. (6 marks)
Up to 2 marks for defining liquidity (ability to meet withdrawals/short-term obligations) and/or profitability (earning returns through lending/investment).
Up to 2 marks for explaining how liquidity is maintained (holding cash reserves, government securities).
Up to 2 marks for explaining how profitability is pursued (issuing loans, investing in less liquid assets).
Full 6 marks require linking the conflict (holding more liquid assets reduces profitability; prioritising profitability through lending reduces liquidity).
Answers should show clear understanding of the trade-off between liquidity and profitability.
