A good way to understand how banks work is to imagine starting your own bank. The first thing you need to do is put up some of your own money. You won't receive a banking license unless you have your own capital at risk.
Getting Started
Let's assume you raise $6 million in cash with help from other investors. That will be the bank's initial equity, the owner's stake. Next you obtain a charter, rent a building, furnish it with all the necessary equipment, hire and train a staff, and open your doors for business.
You'll need to deposit some of your initial stake at the Fed. Those funds will be used to clear checks written by your own depositors. You'll also need to keep enough cash in the vault to meet the demand for withdrawals by your depositors. Let's assume initial expenses of $1.2 million. That leaves $4.8 million, of which you allocate $2 million to vault cash and $2.8 million to your Fed account.
Managing Loans and Other Investments
As your business develops, some customers will deposit their own money to open checking accounts. Others will invest in your savings accounts and certificates of deposit (term loans) which must pay a competitive interest rate. Still others will seek loans from the bank. It is up to you to determine whether prospective borrowers are good credit risks, and will be able to pay the interest charges and return the principal on the specified date.
Accounting Needs
To manage your bank effectively, you need a system of accounts. This will enable you to see the effect of your decisions on the bank's profitability. The most important account is the balance sheet. This shows at any given moment, the bank's assets (what it owns), its liabilities (what it owes to others), and its net worth (what belongs to the owners). Net worth, or equity, is equal to assets minus liabilities. Your equity should remain positive and preferably growing. If it ever gets too low relative to total assets, your regulator may close the bank.
Balance Sheet and Earnings Forecasts
If your bank does well, the balance sheet will expand with new assets and liabilities. The equity should also increase, assuming you retain some of the profits in the bank rather than pay them all out as dividends to the owners. You started with initial equity of $6 million. Let's take a look at the balance sheet after you have been in business for some time. It is shown together with an earnings forecast for the coming year.
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