Introduction to Banking and Financial Markets

Prof. PC Narayan
How and Why are Banks Different From Manufacturing
Companies? Part 2

In the previous video, we learnt about the winding down of a manufacturing company. What we will go through
in this video is to look at a similar situation for a bank and see how different it would be vis--vis a manufacturing
company. As you might already be aware, the composition of Assets and Liabilities on the balance sheet of a
bank is very different to a manufacturing company? Let's see how.
There is very little difference in interpreting Equity Capital, Retained Earnings and Long Term Borrowings
between a manufacturing company and a bank. Equity Capital and Retained Earnings and Long Term Borrowings
of 1,500. A substantial part of the Liabilities side of the balance sheet of a bank stems from the deposit it takes
from customers which in this case is 10,000 and an additional 500 which it has borrowed from the Call Money
Market. Therefore, the total Liabilities of this institution adds up to 12,000. How has this bank deployed the
12,000 currency units on the Assets side of its balance sheet? It has given Loans of 5,000. It has invested in
Government Securities or Treasury Bonds, as it is known in some countries, 2,500. Corporate Bonds, 2,000. Other
Investments, 1,800. It has a Cash and the total adds up to 12,000.
Now, let's say this bank with a balance sheet size of 12,000 currency units goes insolvent. First of all, we need to
understand what we mean when we say a bank goes insolvent. Insolvency, normally stems from the fact that
the bank's loans and investments are impaired. Now, what do I mean by loans and investments are impaired?
Clients who borrowed from their banks are not repaying their loans and/or the investments that the bank has
made are showing a mark-to-market loss. Say, a bond that the company purchased for 102 currency units is
today worth only 85 currency units. So, it's sitting on a loss of 17 currency units on that bond investment. What
this means is that the mark-to-market value of those investments have gone down. Now, how the value of bonds
go down is something we would see in a later session. The important thing to bear in mind though is when the
loans and investments get impaired, the deposit holders, that is the customers who put their money in the bank
are the ones who get into a state of panic because the customers are afraid that if the borrowers don't repay
their loans or the bonds do not recover in value, the bank might not be able to repay the depositors when their
money is due. Hence, the depositors start to withdraw their deposits prematurely.
Let us say in the case of this bank, panicky customers queue up at the doorstep of the bank saying, "We want to
withdraw our money!" And let's say out of the 10,000 currency units of deposits that the bank has at the
moment, 2,000 currency units are to be withdrawn now. Where will the bank find the money to repay these
depositors who want to withdraw their funds? First of all, the bank would go and sell off the Treasury Bonds
that it has invested in to the extent of 1,300. So, the bond portfolio which was 2,500 now becomes 1,200 and
the 1,300 is raised as cash. The bank already has cash of 700, so now it has liquid cash of 2,000 currency units
which is what it would use to pay off the depositors demand of 2,000 currency units.
So, the revised balance sheet of the bank now is going to look like T-Bonds 1,200, Corporate Bonds 2,000, Other
Investments remain unchanged at 1,800. So, the total Assets side is 10,000 and the Total Liabilities are 10,000.
In other words, the 2,000 that was realised on the Assets side has been used to pay down the depositors. So,
the deposits have come down by 2,000 andso the bank's balance sheet has shrunk from 12,000 to 10,000.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for
use only with the course FC201.1x titled Introduction to Banking and Financial Markets- I delivered in the online
course format by IIM Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval
system or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise
without the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Introduction to Banking and Financial Markets

Prof. PC Narayan
How and Why are Banks Different From Manufacturing
Companies? Part 2

What if this situation worsens? Say, there is more bad news and hence more customers are scrambling to
withdraw their deposits from the bank. Say, the depositors now wish to withdraw 7,000 more currency units,
now! In other words, the bank's deposits are going to come down from 8,000 currency units to 1,000 currency
units. More importantly, the bank will now have to source 7,000 currency units of cash if they have to be able
to meet their obligations to their depositors.
How's the bank going to achieve this? It would sell off all its T-Bonds and raise 1,200. It would sell off Corporate
Bonds worth 1,500 and it would sell off Other Investments an 800 here, the total adds up to 4,500 currency
units. Important thing is the bank is not able to liquidate any more assets than the 4,500. Now, remember the
depositors are clamoring for 7,000 currency units. By liquidating its assets, it has raised 4,500 currency units. So,
it still has a shortfall of 2,500 currency units which it must somehow source to be able to repay the scrambling
depositors.
Remember, the bank cannot sell any more assets because all their liquid assets have already been sold off or
liquidated. And therefore, the bank now has no choice except to go out and raise additional 2,500 currency units
of capital. If a Good Samaritan comes along and infuses 2,500 currency units, it would be able to bail itself out
of the current situation that it has got itself into. The net result being the balance sheet further shrinks to 5,500.
It has an additional capital of 2,500. It has got zero cash and all of these investments are illiquid investments. So,
in other words, with this capital infusion it was able to meet its cash outflow but the bank's balance sheet is now
frozen because it cannot liquidate any more of its assets.
When there is a run on the bank as we say of the type that we just saw where customers have already withdrawn
9,000 currency units, initial 2,000 plus a 7,000, the bank is in a very delirious situation and if at some point, the
remaining 1,000 currency units have also got to be paid off to depositors, the bank does not have the resources
and hence, will simply have to fold up. The Equity shares of this bank is 1,000, Long Term Debt 500, Additional
Capital Infused 2,500, Deposits from Customers 1,000 and Borrowings from the Call Money Market 500. All of
these are stuck because none of these assets can be liquidated and there is no more opportunity for the bank
to raise resources except perhaps through another infusion of capital like our Good Samaritan who brought in
2,500 which seems immensely infeasible.
Why is that the case? Because the bank has impaired assets like bad loans of 4,000 currency units which are
non-performing and can never be recovered. Corporate Bonds of 500 currency units which are illiquid. Other
investments of 1,000 currency units which would also be illiquid and hence cannot be sold in the secondary
market.
This situation you realise is clearly different to the orderly winding down of the manufacturing company that we
saw in the earlier video where the loss on winding down the manufacturing company of 700 currency units was
entirely borne by the Equity shareholders. In the case of the bank, all the Liability holders have had to suffer a
loss because the bank had illiquid assets which could not be sold off.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for
use only with the course FC201.1x titled Introduction to Banking and Financial Markets- I delivered in the online
course format by IIM Bangalore. All rights reserved. No part of this document may be reproduced, stored in a retrieval
system or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise
without the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)