Banks Chapter II

Commercial Banking Commercial banking is highly regulated because of its importance in keeping the public confidence. Regulations mainly address the capital which must be maintained, activities engaged, deposit insurance, and foreign ownership.

Capital Requirements of A Small Commercial Bank Summary Balance Sheet for DLC at end of 2009 ($ millions) AssetsLiabilities and net worth Cash5Deposits90 Marketable Securities10Subordinated long-term debt5 Loans80Equity capital5 Fixed Assets5 Totals100Totals100

Capital Requirements of A Small Commercial Bank Summary Income Statement for DLC in 2009 ($ millions) Net interest income3.00 Loan losses-0.80 Noninterest income0.90 Noninterest expense-2.50 Pre-tax operating income0.60

Capital Requirements of A Small Commercial Bank Suppose there is a severe recession and as a result the bank’s loan losses rise by 3.2% of assets to 4% next year. We assume that other items on income statement are unaffected. The result will be a pretax net operating loss of 2.6% of assets ( =-2.6).

Capital Requirements of A Small Commercial Bank Assuming a tax rate of 30%, this would result in an after-tax loss of about 1.8% of assets. In balance sheet, equity capital is 5% of assets, and so an after-tax loss equal to 1.8% of assets which can be absorbed. It would result in a reduction of equity capital to 3.2% of assets.

Investment Banking: Example The bank can either offer the client a best efforts arrangement where it charges a fee of $0.30 per share sold so that, assuming all shares are sold, it obtains a total fee of 0.30 x 50 = 15 million dollars. Alternatively, it can offer a firm commitment where it agrees to buy the shares from ABC Corp. for $30 per share.