Final answer:
A bank's balance sheet includes cash, securities, and loans, but not all assets are physical cash; they may be invested or loaned out. In the secondary loan market, loan values vary based on the borrower's payment history, changes in interest rates, and the borrower's profitability.
Step-by-step explanation:
Understanding the Balance Sheet and Loan Valuation
When analyzing a bank's balance sheet, it's crucial to realize that the money listed under assets may not be physically present in the bank. Assets on a bank's balance sheet often include cash and cash equivalents, investments such as bonds, and loans issued to customers. Financial institutions operate under the principle of fractional reserve banking, where only a fraction of the bank's deposits is kept in reserves, and the remaining funds are utilized for loans or to buy securities like bonds.
In the secondary market, the value of a loan can fluctuate based on various factors. If a borrower has been consistently late on loan payments, a financial institution may value the loan for less due to the increased risk of default. Conversely, if interest rates in the economy rise after a loan is issued, the existing loan may become less attractive as it now represents an opportunity cost when newer loans could be issued at higher rates. Consequently, its value could decrease.
An example where a loan's value might increase is when a borrower, particularly a corporation, has declared a high level of profits, which suggests improved financial strength and a higher likelihood of timely repayment. Lastly, if the economy's overall interest rates have dropped since the loan was made, the loan's value could increase because its fixed interest rate may now be higher than the current market rates, making it a desirable asset for yield-seeking investors.
Key Takeaways from a Bank's Balance Sheet
- The money represented on the balance sheet may be tied up in loans or invested in securities, like government bonds.
- A bank's assets include reserves, which are a small portion of the deposits actually held in cash by the bank.
- The valuation of loans on the secondary market is influenced by the borrower's payment history, current economic interest rates, and the borrower's financial health.