Introduction to Finance

Secondary reserves 
are short-term 
securities held by banks that are quickly converted into cash at little cost to the banks. For example, 
the holding of U.S. Treasury bills is an important source of secondary reserves for most banks. 
Banks would prefer to hold secondary reserves over primary reserves because interest is earned 
on secondary reserves. On the other hand, secondary reserves are less liquid than cash assets and 
thus provide a little more liquidity risk than do primary reserves. In Figure 3.5, both short-term and 
long-term securities are grouped together under the heading “securities.” As a consequence, we 
cannot readily estimate the average amount of secondary reserves held by banks.
Let’s not lose sight of the fact that banks are in business to make profi ts for the bank 
owners. Banks accept deposits from savers and, in turn, make loans to businesses and indi-
viduals. Figure 3.5 shows that nearly three-fi fths of bank assets are in the form of loans. Bank 
loans are generally less liquid and have higher risks of default than other bank assets. As a 
consequence, bank loans off er higher potential profi t than do other securities. Thus, after 
setting primary reserve and secondary reserve targets, banks concentrate on meeting loan 
demand by individuals and businesses. 
Credit (default) risk
is the likelihood that borrowers 
will not make interest and principal payments. Higher interest rates can be charged to riskier 
borrowers, but such customers also are more likely to default on their loans. Bank managers 
must trade off the size of their loan portfolios against the amount of credit risk they are willing 
to assume. The acceptance of higher credit risk also increases the likelihood of insolvency.
After primary reserve and secondary reserve targets have been set, loan demand met, and 
bank fi xed asset decisions have been made, remaining funds are invested in longer-maturity 
securities. Included would be U.S. government notes and bonds, state and local government 
debt securities, and other securities. These are riskier than the short-term securities held as 
secondary reserves and, thus, off er higher potential profi tability that is second only to the 
potential profi tability of bank loans.