How to start a public bank: A Modeled Exercise

The earnings forecast is based on expected earning rates of the bank's assets and the cost of borrowed funds. Also shown is the expected cost of operations or fixed costs, covering rent, insurance, utilities, salaries, etc. The entries in blue are items that you might try to modify to see how they would affect the key performance measure, the return on equity. Of course, you must maintain the required minimum ratios set by the regulators.

Growth Management

Note that your equity has grown from $6 million to $10 million due to retained earnings. You have acquired a substantial amount in deposits, some of which are ordinary checking accounts that pay no interest. Others were borrowed at market rates. All deposits whether or not they bear interest have associated costs.

With the additional funds available from deposits, you have redistributed your assets to what you hope will enhance future earnings: $4.5 million in reserves, $7.7 million in Tbills, $1.1 million in loans to other banks, and $110 million in ordinary loans. You project net earnings for the coming year after taxes of $2.06 million. That would be a return on equity of 20.6% and a return on assets of 1.65%, which is quite reasonable performance.

Required Operating Ratios

In the lower left corner of the table are the three ratios that must be kept above minimum values established by bank regulators. The capital ratio is the ratio of a bank's equity to a risk-weighted sum of the bank's assets. The weightings are 0 for reserves, 0 for government securities, 0.2 for loans to banks, and 1.0 for ordinary loans. A minimum capital ratio of 8% is required.

The leverage ratio is the ratio of a bank's equity to the unweighted sum of its total assets. The required minimum is 3%. The reserve ratio is the ratio of a bank's reserves (deposits at the Fed plus vault cash) to its demand deposits, i.e. checking deposits. The required minimum is 10%.

While there is much more to learn about banks, this simplified model outlines the essential details for small banks. Large banks are far more complex institutions. For some of them, lending is a minor part of the business. The next article surveys the main activities of large banks.

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