COMMERCIAL BANK OPERATIONS CHAPTER 13 COMMERCIAL BANK OPERATIONS Copyright© 2012 John Wiley & Sons, Inc.

Overview of the Banking Industry Fewer banks, more branches Many small banks, a few very large banks Holding companies predominate Copyright© 2012 John Wiley & Sons, Inc.

Fewer banks, more branches Less than 7,000 banks: Number of banks has declined significantly as industry has consolidated. About 90,000 banking offices: Number of branches has increased as geographical restrictions on banking have relaxed. The largest 84 banks (about 1% of U.S. banks) hold 73% of total deposits. Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Holding companies predominate A “bank holding company” is a company owning an interest in at least 1 bank. As of 2009, some 5,634 holding companies controlled 5,710 banks with about 99% of U.S. commercial bank assets. Copyright© 2012 John Wiley & Sons, Inc.

The Balance Sheet for a Commercial Bank Uses Sources of = of Funds Funds (Assets) (Liabilities + Capital) Cash Assets Deposit Liabilites Investments Non-deposit Liabilities Loans & Leases Capital Accounts Other Assets Copyright© 2012 John Wiley & Sons, Inc.

Sources of Funds: Liabilities + Capital Deposit Liabilities: Transaction Deposits; Savings Deposits; Time Deposits Non-deposit Liabilities: Fed Funds Purchased; Repurchase Agreements; Other Capital Accounts: Capital Stock; Undivided Profits; Special Reserve Accounts Copyright© 2012 John Wiley & Sons, Inc.

Deposit Liabilities Transaction Deposits: Demand Deposits; NOW Accounts Demand Deposits, also known as checking accounts. NOW (Negotiable Order of Withdrawal) Accounts: pay interest; are just for individuals, governments, and non-profits. Savings Deposits: Savings Accounts; MMDAs Savings Accounts MMDAs (Money Market Deposit Accounts) available to any customer; interest plus limited transactional features. Time Deposits: Certificates of Deposit; Negotiable Certificates of Deposit CDs: Usually under $100,000; non-transferable; terms of 30 days to 5 years. Negotiable (or “Jumbo”) CDs: $100,000 or more; transferable or negotiable in secondary markets; terms rarely exceed 90 days. Copyright© 2012 John Wiley & Sons, Inc.

Non-deposit Liabilities Fed Funds Purchased: Most important non-deposit source of funds. Recall purpose of Fed Funds Market. Banks buy and sell Fed Funds to adjust liquidity-- minimum usually $1 million; usual maturity 24 hours (“overnight”). Repurchase Agreements: Another liquidity adjustment mechanism. Bank sells securities but agrees to repurchase them. Essentially a self-securing loan; usually “overnight” but can last longer. T-Bills are a common form of collateral. Other Borrowings: Eurodollars Bankers’ Acceptances Discount Window Loans Capital Notes or Bonds— usually subordinate to depositors’ claims; may count as “capital” for some regulatory purposes. Copyright© 2012 John Wiley & Sons, Inc.

Direct investments of common or preferred equity. Undivided Profits: Capital Accounts Capital Stock: Direct investments of common or preferred equity. Undivided Profits: Accumulated earnings not paid out in dividends. Special Reserve Accounts: Against losses on loans or securities. Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Uses of Funds: Assets Cash Assets Investments Loans & Leases Other Assets Copyright© 2012 John Wiley & Sons, Inc.

Cash Assets Vault cash (physical currency and coin). Counts against reserve requirements. Reserves at the Fed Required reserves per Regulation D Excess reserves for settling transactions with Fed, check-clearing Fed Funds transactions Balances at other banks Cash items in process of collection Fed funds sold Reverse repurchase agreements Copyright© 2012 John Wiley & Sons, Inc.

Investments: Risk discouraged in favor of liquidity U.S. Treasury securities Agency securities Municipal securities Interest is exempt from federal income tax. Copyright© 2012 John Wiley & Sons, Inc.

Major categories of bank loans: Commercial and Industrial Loans Loans and Leases Major categories of bank loans: Commercial and Industrial Loans Loans to Depository Institutions Real Estate Loans Agricultural Loans Consumer Loans Copyright© 2012 John Wiley & Sons, Inc.

Fast-growing line of business for large banks Lease Financing Fast-growing line of business for large banks Common financing technique for— “fleet assets” (aircraft, ships, etc.) “rolling stock” (trucks, rail cars, etc.) other capital equipment (cranes, generators, etc.) Copyright© 2012 John Wiley & Sons, Inc.

Trading account assets—securities held for resale. Other Assets Trading account assets—securities held for resale. Fixed assets—land, buildings, equipment, etc. Intangibles—goodwill, pre-paids, etc. Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Non-price adjustments Matched-funding loan pricing Loan Pricing: One of the most important management decisions in banking 3 key considerations The “Prime Rate” Base rate pricing Non-price adjustments Matched-funding loan pricing Copyright© 2012 John Wiley & Sons, Inc.

Key considerations in loan pricing Earn a high enough interest rate to cover the cost of loanable funds Recover administrative costs of originating and monitoring the loan Provide adequate compensation for risk— Credit (or default) risk Liquidity risk Interest rate risk Copyright© 2012 John Wiley & Sons, Inc.

The “Prime Rate” Historically a benchmark rate The lowest loan rate posted by commercial banks The rate banks charged their most creditworthy customers Other borrowers were typically charged some spread above prime Recently, the role of the prime rate has changed Over the last 20 years, fewer loans have been priced using “prime” Now, lenders choose among several other benchmark rates: LIBOR Treasury rates Fed Funds rate Copyright© 2012 John Wiley & Sons, Inc.

The “Prime Rate” (continued) Popular media still use Prime Rate as barometer Banks sometimes lend below prime Some large, financially sophisticated customers also have access to the commercial paper or Eurocurrency market Most below prime loans are made by large money center banks Copyright© 2012 John Wiley & Sons, Inc.

Base-rate loan pricing Marking up from a minimum offered to the least risky borrowers Possible base rates: Prime, LIBOR, Treasury, Fed Funds Markups include three adjustments: For increased default risk For term-to-maturity For competitive factors — a customer’s access to alternatives rL = BR + DR + TM + CF where: rL = 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 Copyright© 2012 John Wiley & Sons, Inc.

Non-price adjustments Alter the effective return under a given nominal rate Compensating balances Bank requires borrower to carry minimum balance in non-interest-bearing deposit account; effective return increases because net loan amount is lower Other non-price adjustments Risk reclassification Additional collateral or specified collateral Shorter maturities Copyright© 2012 John Wiley & Sons, Inc.

Matched-funding loan pricing Fixed-rate loans are funded with deposits or borrowed funds of the same maturity. A way for banks to control the interest rate risk of fixed-rate loans. Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Analyzing, managing, and pricing credit risk Five “C”s of Credit: 1. Character (willingness to pay) 2. Capacity (cash flow) 3. Capital (wealth or net worth) 4. Collateral (security for the loan) 5. Conditions (economic conditions) Credit scoring based on the information in the borrower’s credit report: 1. Payment history 2. Amount owed 3. Length of credit history 4. Extent of new debt 5. Type of credit in use Default risk premiums for identified risk categories Copyright© 2012 John Wiley & Sons, Inc.

Fee-based services Correspondent banking: sale of bank services to other financial institutions Trust services: management of client wealth Non-banking financial services: investments and insurance Copyright© 2012 John Wiley & Sons, Inc.

Correspondent banking Common correspondent services— check clearing and collection securities foreign exchange participation in large loans data processing Not a recent development, but unique to the U.S. Many small banks need “large bank” services Large banks provide these services Copyright© 2012 John Wiley & Sons, Inc.

Trust services: management of client wealth As fiduciary, bank holds and manages assets for beneficiary Trust function is strictly segregated from other bank functions Common trust services— administration of estates management of pension assets registration and transfer of securities administration of bond indentures Copyright© 2012 John Wiley & Sons, Inc.

Non-banking financial services Investment services, insurance, and other financial products Deregulation allows these services, provided clients clearly understand they are not covered by deposit insurance Banks can compete directly with mutual funds and securities firms Insurance powers of banks are more limited Copyright© 2012 John Wiley & Sons, Inc.

Off-balance-sheet banking Loan commitments: unfunded promises to make loans in the future Letters of credit: written promises to pay third party on client’s behalf Derivatives: forwards, futures, options, swaps Loan brokerage: sale of loans after origination Securitization: assignment of cash flows from assets (usually loans) via securities to investors Copyright© 2012 John Wiley & Sons, Inc.

Loan commitments Lines of credit Term loans Revolving credit allow total advances up to a limit Term loans certain dollar amount longer than 1 year Revolving credit lines of credit allowing payment and re-borrowing within limit Copyright© 2012 John Wiley & Sons, Inc.

Commercial letters of credit— client buys goods and services bank promises to pay seller on behalf of client seller presents bank with draft Standby letters of credit— bank guarantees client’s financial performance of some contract client’s counterparty relies on bank’s creditworthiness, not borrower’s beneficiary presents draft to bank if client does not perform Common uses of SLCs— securities offerings credit enhancement of other debts completion of projects Copyright© 2012 John Wiley & Sons, Inc.

Derivatives: forwards, futures, options, swaps Usual subject matter is interest rates or currencies Uses of derivatives— Hedging of risk exposure (acceptable to regulators) Speculation on market swings (less acceptable to regulators) Copyright© 2012 John Wiley & Sons, Inc.

Loan brokerage Sale of loans after origination Restores liquidity and earns fees Avoids regulatory burden of loans on books Copyright© 2012 John Wiley & Sons, Inc.

Securitization Assignment of cash flows from assets (usually loans) via securities to investors—bank transfers assets to trust; sells ownership units in trust Similar rationale to loan brokerage Banks can underwrite securitizations themselves after deregulation Copyright© 2012 John Wiley & Sons, Inc.

Bank Earnings Major sources of income: Interest on loans, interest earned on investment securities, fees and service charges Major expenses: Interest paid on deposits, payment for federal funds, repurchase agreements, and borrowed money, provision for loan losses, noninterest expenses Net interest margin: Difference between gross interest income and gross interest expense Copyright© 2012 John Wiley & Sons, Inc.

Income Statement for Commercial Banks Copyright© 2012 John Wiley & Sons, Inc.

Bank Earnings (continued) Copyright© 2012 John Wiley & Sons, Inc.

Bank Earnings (continued) Copyright© 2012 John Wiley & Sons, Inc.

Bank Earnings (continued) Copyright© 2012 John Wiley & Sons, Inc.

Return on average assets (ROAA) (net income/average total assets) Bank Performance Return on average assets (ROAA) (net income/average total assets) Return on average equity (ROAE) (net income/average equity capital) Copyright© 2012 John Wiley & Sons, Inc.

Bank Performance (cont.) Copyright© 2012 John Wiley & Sons, Inc.

Bank and Financial Holding Companies De facto branching Multibank holding companies circumvent branching restrictions Recent deregulation makes branching easier Diversification into nonbank services Fed allows certain nonbank subsidiaries within a holding company BHCs with acceptable Community Reinvestment Act ratings can qualify as “financial holding companies”—can have subsidiaries related to almost any financial service Tax avoidance Interest paid on debt is tax-deductible Most dividends received from subsidiaries are tax-exempt Nonbank subsidiaries can be structured to avoid local taxes Copyright© 2012 John Wiley & Sons, Inc.

Financial Holding Companies Copyright© 2012 John Wiley & Sons, Inc.