This section is an introduction to what balance sheets are, with an emphasis on financial firms. It will also cover some of the jargon used in this text. If the reader is completely unfamiliar with accounting, it may be necessary to supplement this material with other primers. The focus on this text is the economic principles of banking, and not the highly specialised accounting used in the industry.
A balance sheet is a static snapshot of the situation of a firm at one time (the end of an accounting period). It shows what the firm owns, what is owes to others, and the accounting value of the ownership of the firm (which may or may not bear any resemblance to the market value of the firm). Just looking at balance sheets is largely enough for the purposes of this book. However, accounting also needs to track what is happening over time – is the firm making money? The income statement measures the profit or loss over an accounting period. Although profits are important, this text will not look at income statements, so they will be skipped in this introduction.
Balance Sheet Basics
There are three main categories of line items on a balance sheet: assets, liabilities, and owner’s equity (or equity). Each line item has an associated total dollar value for all individual goods/instruments within a category. (This book uses “dollar value” as a shorthand for any quantity that is valued in the local currency. Although being dollar-centric is unfortunate for my readers in Europe, alternatives are too clumsy.)
Assets are what the firm owns. If we add up the value of all the asset line items, the sum represents the theoretical value of everything the firm owns.
Liabilities are what the firm owns to others. For financial firms, these mainly correspond to debts, but debts are a specific sub-category of liabilities.
Owner’s Equity (or Equity) is the theoretical value of what the owner’s of the firm would get it if were shut down – assets are sold, and liabilities are paid off.
The relationship between these items is:
Assets = Liabilities + Equity.
We can re-arrange this to see that Equity = Assets – Liabilities, which corresponds to the statement that the value of the owner’s stake in the firm is equal to the value of its assets less what it takes to pay off its liabilities.
The normal format for writing out a balance sheet is to put assets on one side, and liabilities/equity on the other. It is called a balance sheet since the two sides must balance (equal each-other). If your intern hands you a spreadsheet that does not in fact balance, you can be sure that they made an error somewhere.
In the above explanation, there was an embedded assumption that is extremely dubious for non-financial firms but is somewhat plausible for financial firms. The assumption is that the balance sheet value of an asset is equal to what it could be sold for in a liquidation. A non-financial firm is unlikely to receive the balance sheet value of equipment assets if it were forced to sell them in auction. Going the other way, land values on a balance sheet may reflect the historical purchase cost decades earlier, and the liquidation value could be much higher than the value that is “carried” on the balance sheet. However, for a financial firm, most of its assets and liabilities are forms of debt instruments. In the absence of a default, the value of instruments if sold tend to be relatively close to their balance sheet value. If one wants to look at accounting statements of real-world firms, one is forced to deal with the nuances of how items are valued on a balance sheet. For our purposes here, we will just assume that balance sheet values correspond to the outstanding debt balance.
Leverage
One key concept in finance is leverage: the use of borrowing to enhance the returns on equity. If one wants to dig into the “innovations” produced by academics in finance, they almost invariably amount to finding ways to express leverage in new and exciting ways (t\and hat are not understood by risk managers until after the financial crisis).
Imagine that there is $100 bond that pays 6% interest, and we think it is so attractive that we want to set up a new (very small) firm to buy it.
The first way is to inject $100 cash into the new firm, which buys the bond. (Note: in this text, when I write “cash” it generally means “short-maturity assets, including ‘money’.” This reflects the way the term is used in finance, where “cash” is a class of assets in a portfolio allocation – typically money market funds. This overlaps with “cash and cash equivalents,” which is a standard line item on balance sheets. Although one might want to use “money” instead of “cash,” we run into the mysticism that economists have created around the concept of “money.”)
The balance sheet is straightforward: the firm has $100 in assets (the bond), and no liabilities. The firm equity is thus $100 – matching the amount of cash injected into the firm.
Since the asset pays 6% interest, the firm will earn $6 in interest per year. This means that the profits are 6% of the equity of the firm. That is, if the firm has 100% of the liability/equity side of its balance sheet as equity, the return on equity equals the return on the assets.
Although 6% might be nice, it is not a very exciting return on equity. The way to pump up the return on equity is apply leverage. Let us imagine that somebody was willing to lend the firm $90 at an interest rate of 5% per year. This would allow the owner of the firm to buy the same $100 piece of the bond with an injection of $10.
The balance sheet in this case changes on the liability/equity side: there is a $90 loan, and $10 in equity. (Assets are unchanged.) But profits are different. The firm will earn $6 per year from the bond, but now pays $4.50 in interest on the loan it took out. This means that the profit is $1.50 per year. Although that looks worse, it is much better when we look at the return on equity. A $1.50 profit on an investment of $10 is equal to a return of 15% on equity. (An equivalent way to structure this is for the firm to have an initial investment of $100, and borrow $900, and buy a $1000 piece of the bond. The return on equity is the same. What has happened is that the firm can expand its balance sheet by borrowing.)
“Financing”
Another piece of jargon that shows up is the term financing. The word is used in a variety of ways, but I tend to use it in a way that is typical for fixed income market participants. As I use it, it refers to the structure of the balance sheet thar either corresponds to the whole balance sheet, or possibly just a portion of the balance sheet.
For example, I might describe the previous example as “the firm financed the purchase of $100 in bonds by emitting $90 in debt and $10 in equity.” (“Emitting debt” is a synonym for “issuing debt,” but it avoids the suggestion of the formal procedure that “issuance” has in the financial industry. The economist Hyman Minsky liked using “emit,” in this context, and I think it is a better term.)
We do not need to look at the entire balance sheet. Imagine the same firm expanded its balance sheet by buying a $50 piece of another bond, and it matched this increase by the owners injecting $10 into the firm and going out and borrowing another $40. In this case, we say “the new purchase was financed by emitting $40 in debt and $10 in equity.”
Funding
Another piece of financial jargon that this text uses is funding, which is tied to the wholesale funding markets. This usage of funding is somewhat specialised – when I did a quick search on the internet, the usages I ran into referred to how the term is used in government finance. The wholesale funding markets are the domain of large financial institutions, and the number of people involved in them is small. It seems likely that most people working in the financial industry will have not spend any time thinking about the funding markets (except for the few months around a financial crisis).
As I use the term, it is almost a synonym for financing – as I define it above. The difference is that I use financing to refer to the entire financing structure matching an investment, while funding refers to finding generic liabilities that are expected to be swapped out when it is possible to find cheaper sources. Wholesale funding markets are generally short-term liabilities (or derivative agreements that involve large cash exchanges, like currency swaps) where there is supposed to be no serious risk of default. Important examples of wholesale funding markets are the interbank markets, money markets, repurchase agreements (“repos”), and cross-currency basis swaps. The idea is that if the firm keeps its credit quality at a reasonable high level, it can jump between these markets to get “funding.” Issuing long-term debt or equity requires more credit analysis, and I would refer to them as “financing” transactions. Access to “financing” is sporadic and conditional, while a large firm with short-term liabilities will be continuously operating in the funding markets.
Another important way the term is used refers to transactions internal to firms. The treasury team in a bank will generally act as central team for dealing with wholesale funding markets. Other units within the bank that need cash to operate – or generates cash as part of their operations – will borrow/lend to the treasury team at agreed-upon rates. That is, the treasury team provides internal funding to the other units of the bank. This is discussed in more depth in Section TK.
Concluding Remarks
The financial firms that we are interested in within this text are firms that hold financial assets as part of their business (as opposed to a firm that expects to make a profit via selling services). The assets on the balance sheet need to be matched by liabilities and equity. Relying solely upon equity financing is likely to result in a low return on equity, the firm is likely to emit liabilities that are a significant percentage of the value of assets.
The key difference between banks and other financial firms is the traditional banking component of the firm, which emits deposit liabilities, which behave somewhat differently than other financial liabilities. However, one of the key themes of this book is that the difference between traditional banking and other forms of financing becomes blurred once we look at macroeconomic behaviour.
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