Chapter 13 Commercial Banks Operations

Bank Uses of Funds: Loans and Leases Bank loans and leases are the primary business activity of a commercial bank Account for 59% of all bank assets They generate most of the bank’s profit They take time to arrange Subject to greater default risk Less liquid than other banks investments They do not have special special tax advantage of municipal bonds.

Most bank loans consist of promissory notes. Promissory note: “an unconditional promise made in writing by the borrower to pay the lender a specific amount of money usually at some specified date in the future.” Repayment is made: 1.Periodically (installment) 2.In total on a single date 3.On demand Bank Uses of Funds: Loans and Leases

Bank loans are: 1.Secured: - the security or collateral may be merchandise, inventory, accounts receivable, planet and equipment or stocks and bonds. -It reduces the financial injury to the lender of the borrower defaults 2.Unsecured Bank Uses of Funds: Loans and Leases

-Also Bank loans: 1.Fixed rate: the interest rate on a loan does not change over the loan’s term 2.Floating rate: interest rate is periodically adjusted for changes in the a specified short term rate ( treasury rate or LIBOR) -Most Banks carry fixed rates, assuming all the interest rate risk -Consumers are usually less willing to bear the risk of a floating rate Bank Uses of Funds: Loans and Leases

Types of Bank Loans Commercial and Industrial loans Loans to depository Institutions Real Estate Agricultural Loans Consumer Loans Bank Uses of Funds: Loans and Leases

Commercial and Industrial Loans: -Constitute 11% of total assets. -Most of them are short term loans -Business lending is more important to large banks than small retail banks. -There are three types of business loans depending on the borrower’s need of funds and source of repayment. 1.Bridge Loans 2.Seasonal Loans 3.Long-term Asset Loans Bank Uses of Funds: Loans and Leases

Types of Business Loans 1.Bridge Loans: Supplies cash for a specific transaction with repayment coming from an identifiable cash flows. 2.Seasonal Loan: provides term financing to take care of temporary discrepancies between business revenues and expenses that are the result of the manufacturing or sales cycle of a business. 3.Long-term Asset Loans: loans that finance the acquisition of an asset or assets. Bank Uses of Funds: Loans and Leases

Loans to Depository Institutions -Banks make loans to other banks, saving and loans associations, and foreign banks. -They are usually made by large banks and account for 1% of bank’s total assets Real Estate -Account for 34% of bank’s total assets -Finance the purchase, construction and remodeling of resident housing and commercial facilities. Bank Uses of Funds: Loans and Leases

Agricultural Loans: -Long and short term loans to farmers. -Only 1% of bank’s assets -Important form of lending for small banks (6%) -Generally seasonal and primarily to provide farmers with funds to purchase seeds, fertilizer, and livestock. Bank Uses of Funds: Loans and Leases

Consumer Loans: -9 % of bank’s assets -½ of total consumer installment credit outstanding (it is relatively a new phenomenon). -Maturities and conditions vary with the type of purchase. -Can be short term ( 1 month maturity), and are usually single payment loans. -Or long-term ( 5 years), and are repaid in installment basis. They are usually secured by the purchased item. Bank Uses of Funds: Loans and Leases

Consumer Loans: -Bank Credit Cards: -First plan was in the 1950s -Revolving credit: A line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. ( Investopedia’s definition) -Their were at first local cards issued by individual banks. -Then the nationwide bank-card slips, and nationwide bank licensing of banks to issue credit cards spread their uses among national banks. Bank Uses of Funds: Loans and Leases

Consumer Loans: -Bank Credit Cards: -Visa and MasterCard are the most widely plans used. -Merchant who accept this service pays a service charge (1-4%) depending on sale price and volume. -The holder of the card is guaranteed a credit limit at the time card issued. -Dollar amount of the credit limit depends on the customer’s income and credit rating. Bank Uses of Funds: Loans and Leases

Consumer Loans: -Bank Credit Cards: -If the customer paid (in full) for the used amount within 25 days after the monthly billing, no interest is charged. -However, the customer is not required to pay the full amount within the billing period, but to pay the balance of installments. -The bank sets a minimum monthly payment that must be paid ( 1-2% per month) -Membership fee is between $15- $500 Bank Uses of Funds: Loans and Leases

Lease Financing -Fast growing area of business for commercial large banks. -“it is a transaction whereby the bank purchases property on a customer’s request and lease it to the customer” -Lessee = customer -Lessor = Bank Bank Uses of Funds: Loans and Leases

Lease Financing -Main justification for leasing is taxation: -When lessee is in a lower tax bracket than lessor, leasing an asset becomes a desirable alternative to borrowing and purchasing the asset. -That is because with the lease arrangement: a.Bank get a larger tax deduction b.Pass part of it to the lessee as a discount of lease payment. -Rate of return on leasing (after tax) is comparable to that earned on bank lending. -It is considered an extension of commercial lending activities. Bank Uses of Funds: Loans and Leases

Other Assets: -Trading Accounts: inventory of securities held by banks for resale to investors as part of their securities dealer activities. -They include the same types of investments held in the investment portfolios. -They are listed separately because they are expected to be held for a short term. Bank Uses of Funds: Loans and Leases

Other Assets: -Fixed Assets: real assets, furniture's, banking equipment and bank’s real estate holdings. -Intangible Assets: goodwill, patent, prepaid expenses, income earned but not collected, foreign currency holdings, and direct lease financing. -Small banks have higher proportion of fixed assets. Bank Uses of Funds: Loans and Leases

Loan Pricing What is the price of a loan? One of the most critical decisions made by a bank’s manager Three important facts about loan pricing 1.Interest rate earned must be high en0ugh to cover the cost of funding the loan 2.Rate must sufficient to cover administrative costs of originating and monitoring the loan 3.Interest must provide adequate compensation for the credit risk, liquidity risk and interest risk generated by the loan.

Loan Pricing Prime Rate (base rate): a rate that was historically used for short term business and agricultural loans. It was the rate banks charged their most creditworthy customers. Now, role of prime rate changed. Lenders now choose among a number of benchmarks: -LIBOR: the price of short term Eurodollar deposits -Treasury Rates

Loan Pricing Base-rate loan pricing: -Markups include three adjustments: For increased default risk – Adjusting the borrower’s level of credit risk For term-to-maturity – Adjusting the length of the loan, most business loans are variable loans so the rate adjust up and down with the base rate For competitive factors—a customer’s access to alternatives: the greater the competition, the lower the loan rate.

Base-rate loan pricing: -Expressed mathematically, the loan rate to a particular bank customer is: r L = BR + DR + TM + CF where: r L = individual customer loan rate BR = the base rate DR = adjustment for default risk above base-rate customers TM = adjustment for term-to-maturity CF = competitive factor Loan Pricing

Base-rate loan pricing: Example: - Bank base rate is 7%,two customers a small firm and a large firm want loans. The large firm is well known nationally, has sold commercial paper on occasion, and wants a floating rate loan. The smaller firm wants a 1 year fixed rate loan.1 year T. securities sell for 0.75% above 3 month T-bill. Pricing FactorSmall FirmLarge Firm Base rate7% Default risk adjustment 3%2% Term to maturity adjustment 0.75%0.00 Competitive factor adjustment 1%0.00 Loan rate11.75%9.00% Loan Pricing

Non-Price adjustments: -Compensating balances: minimum average deposit balances that bank customers must maintain at the bank, usually in the form of non-interest-bearing demand deposits. It is usually 10%of the amount of outstanding loan. -It encourages borrowers to use other services of the bank and raise effective loan rate. Loan Pricing

Non-Price adjustments: Example: Assume that a firm has a $100,000 line of credit at an 8% rate of interest that requires a 10% compensating balance. If the firm borrowed the maximum amount ($100,000) for 1 year, it would have to maintain $10,000 in a deposit account with the bank; because the firm has only $90,000 ($100,000-$10,000) available to use during the year, the annual effective rate of interest is 8.9% ($8,000/$90,000), rather than the stated nominal rate of 8% ($8,000/$100,000). Loan Pricing

Non-Price adjustments: Or it can be solved this way Effective Interest Rate (EIR) = Loan Pricing

Non-Price adjustments: 1.Risk reclassification – Reclassifying borrowers from lower to higher credit risk classes (carrying higher loan rates). 2.Additional collateral or specified collateral – Increasing the amount of collateral (lowering default risk). 3. Changing the maturity of the loan (moving along the yield curve) 4.Customer relationship explains why the prime rate tends to be more inflexible to sticky. Loan Pricing

Matched-Funding Loan Pricing: - One way that banks can control the interest rate risk in fixed-rate loans is through matched funding of loans. -Matched Funding: Fixed-rate loans are funded with deposits or borrowed funds of the same maturity. Loan Pricing

Matched-Funding Loan Pricing: A bank makes a 1-year fixed-rate loan, it might fund the loan with a 1-year CD. Assuming that the cash inflows from the loan match the cash outflows on the CD, the bank is able to reduce interest rate risk because if interest rates change, the rate on the loan and the CD change by approximately the same amount because they have the same maturity. Loan Pricing

Analysis of Loan Credit Risk One of the lending officer’s major tasks is to analyze a customer’s creditworthiness ( to determine a customer’s default risk premium). It is illegal for banks to discriminate on basis of sex, race, religion, or martial status, only economic factors can be considered.

To quantify a customer’s default risk characteristics, banks analyze the five Cs of credit: 1.Character (willingness to pay): Integrity, credit history and past business relationship with the bank 2.Capacity (cash flow): borrower’s projected income statement. 3.Capital (wealth or net worth): borrower’s balance sheet, or residual wealth 4.Collateral (security for the loan) 5.Conditions (economic conditions ) Analysis of Loan Credit Risk

Credit Scoring: -Is an efficient, inexpensive, and objective method for analyzing a potential borrower’s characteristics. -It involves assigning a potential borrower a score based on their information in the borrowers credit report. -Higher credit score indicates a lower risk of default. Analysis of Loan Credit Risk

Credit Scoring: -Credit scoring model focuses on five factors: 1.Payment history 2. Amount owed 3.Length of credit history 4.Extent of new debt 5.Type of credit in use Analysis of Loan Credit Risk

Credit Scoring: -Advantages: 1.Allows lenders to make very fast loan decisions. 2.Scoring is made based on objective criteria which minimize the potential for discriminatory lending practices. -Disadvantages: 1.Impersonal and does not allow for special circumstances 2.Secretiveness behind credit scoring models makes it difficult for potential borrowers to improve their score. Analysis of Loan Credit Risk

Default Risk Premium: -Five Cs analyzed  customer assigned to a credit rating category. -Default risk premium for each category is determined from the analysis of the bank’s credit losses over several business cycles. Analysis of Loan Credit Risk

Default Risk Premium: For example a bank with five credit categories may develop the following loan-pricing scheme: Credit CategoryDefault Risk Premium 1Prime-rate Customers Basis points Basis points Basis points 5Reject Credit Analysis of Loan Credit Risk

Pricing Bank Deposits -Most of bank’s funds come from deposits. -Another important decision of bank managers is determining the interest rates offered to depositors. -Banks must offer depositors high enough rates to attract and retain a stable deposit base -If it offers a very high rate that squeeze the spread between the average return on assets and the average cost of liabilities, bank profitability suffers.

Competition puts pressure on the “spread” from both sides bank may have to charge lower rates on loans bank may have to pay higher rates on deposits Pricing Bank Deposits

End of Chapter 13