Chapter 13

COMMERCIAL BANK OPERATIONS

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Importance of Commercial Banks

Large financial institutions Widely diversified in their business activities The principal transmitter of monetary policy The center of the payments mechanism The place that small savers first participate in intermediation On-Line Banking
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An Overview of the Banking Industry Today

The commercial banking industry is comprised of about 7,800 banks. The number of banks has declined from a peak of 15,000 in 1980. Commercial banks' geographic expansion has been constrained by state and federal banking legislation, but these constraints have been almost eliminated. Consequently, while the number of banks has declined, the total number of bank offices has grown to over 70,000.
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Number of Banks and Branches, 1920-2001

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An Overview of the Banking Industry Today (concluded)

The decline in the number of banks can be attributed to the rapid pace of consolidation in the industry. Large banks dominate asset and deposit holdings in the industry.

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Liabilities and Capital Accounts of Commercial Banks, 9/30/01

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Bank Sources of Funds -- Liabilities and Capital

Demand deposits accounts (DDA) represent funds transferable on the presentation of a check written by a customer.

Treasury deposits are called tax and loan accounts and are held at many banks

Savings Accounts -- Traditional nontransaction bank deposits. Certificates of Deposit -- Deposit contracts issued for a specific period of time. The largest category of bank deposits.

Negotiable Certificates of Deposit

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Bank Sources of Funds -- Liabilities and Capital -continued

Borrowed Funds -- Nondeposit, uninsured sources of funds. Federal Funds - typically have a maturity of one day

Generally $1 million or more in trading units

Repurchase Agreements also typically one day maturity and are for $1 million or more EURODOLLARS - tied to LIBOR Bankers Acceptances Federal Reserve Bank loans from district bank

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Bank Sources of Funds -- Liabilities and Capital (continued)

Capital Notes and Bonds -- Nondeposit, noninsured, subordinated long-term notes and bonds. Bank Capital Accounts

a source of funds. an equity base for deposits. a residual, at risk source of funds from shareholders that is used to absorb losses and protect depositors.
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Liabilities and Capital Accounts

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Assets of Commercial Banks, 9/30/01

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Uses of Funds -- Bank Assets

Cash assets

Vault cash provides bank with funds to meet the needs of the public Vault cash can count towards legal reserve Cash Items in the Process of Collection

Federal Funds sold represent excess reserves sold to other banks for a short period of time. Bank investments provide income and liquidity.

U.S. Treasury securities offer safety, liquidity, marketability, collateral, and income. U.S. government agency securities provide safety and income. Municipal securities provide income and a tax shield
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Bank loans
Loans are generally more risky than the investment portfolio. Bank loans consist of promissory notes -- a financial asset similar to securities. Banks make fixed rate or floating rate loans. Many loans are secured by collateral; others are unsecured.
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Commercial and Industrial Loans

About 11% of total assets Bridge loans -- a business financing agreement with repayment coming from the completion of the agreement. Seasonal loans -- financing of varying working capital needs over a year with repayment coming from the reduction in working capital. Long-term asset loans -- financing equipment over several years with repayment coming from future profits and cash flows of the borrower.
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Other Loans
Loans to depository institutions -- loans to respondent banks, S&Ls, and foreign banks. Real estate loans -- fixed or variable rate long-term loans

account for 30% of total assets residential mortgage loans (18%)

Home Equity Loans

commercial and industrial real estate loans

Agricultural loans

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Other Loans (concluded)

Consumer loans to individuals

most are paid back in installments includes credit cards About 10% of total assets

Bank Credit Cards -- credit extended to consumer at the time of purchase and/or cash advance:

once local, credit card networks are now worldwide bank earns fees from annual fee, merchant discount and interest on revolving credit balances Taxation is the key economic justification.
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Lease Financing

Trading Account Assets

Trading accounts represent the inventory of securities held by banks for resale to investors as part of their securities dealer activities. Represents about 5% of total assets Trading account assets are concentrated in large banks.
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The Prime Rate

The commercial loan index rate posted by banks. Traditionally, most loans were tied to the prime rate, but today other market rates such as LIBOR, Treasury or CD rates are used as loan pricing reference rates. The prime rate remains a popular media indicator of changing credit conditions. The prime rate lags or follows market rates.

Rate as of April 4th, 2005 was 5.75%. Finance 308

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Base Rate Loan Pricing

Most banks use a base rate of interest as a markup base for loan rates. The base rate may be the prime rate, the Federal Funds rate, LIBOR, or the Treasury rate and is expected to cover the following:

the cost of funds of the bank. the bank's administrative costs a fair return to the bank shareholders
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Base Rate Loan Pricing Factors

An upward adjustment from prime for default risk. An adjustment for term to maturity. An adjustment for competitive factors. rL = BR + DR + TM + CF
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Compensating Balances
Compensating balances are the minimum average deposit balances that bank customers must maintain at the bank, usually in the form of noninterest-bearing demand balances More used in the past

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Matched-funding Loan Pricing

Fixed-rate loans are funded with deposits or borrowed funds of the same maturity The loan rate is determined by adding a spread to the deposit cost to cover administrative costs, default risk, and a competitive return to bank shareholders. By matching the maturities of sources and uses, changing market interest rates are less likely to affect bank earnings.
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Analysis of Loan Credit Risk: The 6 Cs of Credit

character -- willingness to pay. capacity -- cash flow. capital -- wealth. collateral -- pledged assets. conditions -- current economic conditions country Where is the loan being made?

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Fee-Based Services
Fee-based services have become important sources of bank revenue. Correspondent banking involves the sale of bank services to other banks and institutions. Check clearing and collections Purchase of securities Purchase and sale of foreign exchange Participation in large loans
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Fee-Based Services - continued

Bank leasing is an important type of credit service. Trust operations

Act in a fiduciary capacity for customers, such as a corporation or the estate of a deceased person Pension Fund management Transfer Agent for corporations

Brokerage and Mutual Funds Investment Banking

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Fee-Based Services (continued)

Investment products such as brokerage services and mutual funds are relatively new, but increasingly important sources of fee income. Financial Holding CompaniesMay own insurance underwriting and investment banking companies.
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Off-balance Sheet Banking

Off-balance-sheet activities are fee-based activities that give rise to contingent assets and liabilities.

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Off-balance Sheet Banking (continued)

Loan commitments enable lender and borrower to plan future cash flows.

A line of credit is an informal agreement between the bank and customer to lend up to a maximum amount (less than 1 year). A term loan is an amortized payment loan agreement for a period exceeding a year. A revolving credit (revolver) is a formal agreement to lend a maximum amount for a period of time, usually greater than one year.
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Off-balance Sheet Banking (continued)

Letters of credit

A commercial letter of credit involves a bank guaranteeing payment for goods in a commercial transaction. A standby letter of credit (SLC) is a contingent liability whereby the bank guarantees the terms and contract of a customer.

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Off-balance Sheet Banking (continued)

Loan brokerage involves the origination and sale of loans. The bank earns a fee for origination and servicing. The lending is provided by other direct or indirect investors. Derivative securities such as interest rate and currency forwards, futures, options, and swaps are an increasingly important part of banks off-balance-sheet commitments.
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Loan Brokerage
Most bank loans are sold without recourse because of capital requirements Banks earn fee income Permits banks to invest in and diversify across a different set of loans May have a competitive advantage in certain types of loans Sell loans to avoid regulatory taxes Federal insurance premiums Forgone interest on required reserves Mandatory capital requirements
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Off-balance Sheet Activities

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Securitization
Mortgage (including home equity loans), auto, or credit card loans or leases are pooled together in a trust arrangement. Securities, called certificates, are sold to individual and institutional investors. The cash flow collections from the loans are forwarded to the trust and investors. Asset-Backed Securities (ABS)
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Securitization (concluded)
The bank earns loan origination fees, perhaps underwriting fees, and loan servicing fees, and the funds raised by the securitization are used to originate more loans. Securitizing loans enables the bank to generate fees without added bank equity capital, required reserves (no funding needed), and deposit insurance premiums. (Regulatory Taxes) Bank does not have the risk associated with purchasing an asset or corresponding liability on its balance sheet. Less expensive source of funding
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The Structure of a Typical Asset Securitization

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Bank Holding Companies

The bank holding company is the major form of organization for banks in the United States and was used:

To achieve geographic expansion. To offer traditional nonbanking financial services. To reduce their tax burden.

The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act allowed banks to acquire banks in other states.
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Bank Holding Companies

(concluded)
Bank Holding Companies were first regulated under the Bank Holding Company Act of 1956, with major amendments made in 1970 to include one-bank holding companies under the definition of a bank holding company.

There was a concern about concentrated economic power and concern that troubled bank holding companies could undermine the confidence in commercial banks. The Federal Reserve regulates bank holding companies. Approximately 90% of bank holding companies are onebank holding companies.
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Financial Holding Companies

Financial Services Modernization Act of 1999 Extended list of allowable financial activities for Fed certified financial holding companies Insurance underwriting and investment banking

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Conclusion
Importance of Banking Bank Liabilities and Capital Bank Assets Prime Rate Base-Rate Loan Pricing Matched-Funding Loan Pricing Fee-based services Off-balance sheet banking Securitization Bank Holding Companies
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