Chapter Eleven Commercial Banks

Chapter Outline Depository Institutions Definition Typical Characteristics of Commercial Banks Trends in Commercial Banks Bank Size and Activities Regulation

1. Depository Institutions Financial Institutions that: Accept deposits (Insured by government) Make loans Have access to payment system Are heavily regulated Three major groups Commercial banks Savings institutions Credit Unions

2. Commercial Banks Largest group of depository institutions Major liability includes deposits; nondeposit sources of funds include subordinated notes and debentures Loans are broader in range than savings and credit unions: commercial, real estate, consumer, etc. Deposits insured by FDIC Regulated separately from savings institutions and credit unions: Federal Reserve, Office of the Comptroller of the Currency (OCC), FDIC

Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets Liabilities Assets Liabilities Loans Deposits Deposits Loans Other Other financial financial assets assets Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

Commercial Bank Balance Sheet (b$, 2004) Assets Total cash assets………………. $ 416.9 U.S. gov securities…………… $ 1047.4 Fed Funds/Repurchase………. 384.6 Other…………………………. 447.3 Investment securities………….. 1,879.3 Interbank loans………………. 193.6 Loans exc. Interbank………… 4624.3 Comm. and Indust…………..$ 890.1 Real estate…………………… 2,544.9 Individual……………………. 806.3 All other……………………… 383.0 Less: Reserve for losses……… 78.1 Total loans……………………… $4,739.8 Other assets…………………….. 1,208.4 Total assets…………………….. $8,244.4

Commercial Bank Balance Sheet (b$, 2004) Liabilities and Equity Transaction accounts…………… $ 716.9 Nontransaction accounts………... 4,689.1 Total deposits…………………… $5,406.0 Borrowings……………………… 1,769.6 Other liabilities………………….. 247.4 Total liabilities………………….. $7,423.4 Equity…………………………… 821.4

Commercial Bank Balance Sheet (2004) Assets Total cash assets………………. 5.1% U.S. gov securities…………… 12.7% Fed Funds/Repurchase………. 4.7% Other…………………………. 5.4% Investment securities………….. 22.8% Interbank loans………………. 2.3% Loans exc. Interbank………… 56.1% Comm. and Indust………….. 10.8% Real estate…………………… 30.9% Individual……………………. 9.8% All other……………………… 4.6% Less: Reserve for losses……… 0.9% Total loans……………………… 57.5% Other assets…………………….. 14.6% Total assets…………………….. 100%

Commercial Bank Balance Sheet (2004) Liabilities and Equity Transaction accounts…………… 8.7% Nontransaction accounts………... 56.8% Total deposits…………………… 65.5% Borrowings……………………… 21.5% Other liabilities………………….. 3.0% Total liabilities………………….. 90.0% Equity…………………………… 10.0%

Industry Performance A well run bank usually has an ROA of 0.5% to 3%. To get an acceptable ROE, banks must resort to using a very high amount of leverage; the debt/asset ratio at a bank is usually over 90%. The average ROA and ROE for commercial banks in 2003 is 1.40% and 15.31%, respectively, compared to 1989 when ROA and ROE averaged 0.49% and 7.71%.

2.1 Trends in Commercial Banks Portfolio Shift As a percentage of the typical bank’s balance sheet, over the last 50 years, mortgages have risen and securities have fallen Loss of Market Share 20 years ago banks had 40% share 10 years ago banks had 26% share Today banks have 19% share

2.2 Trends in Commercial Banks Movement toward off-balance sheet activities Movement away from net spread income (interest income minus interest expense) Movement toward fee income

Balance Sheet Items Assets Liabilities Equity loans and investment securities Liabilities transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts NOW account - an interest-bearing checking account negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market Equity common and preferred stock, surplus or additional paid-in capital, and retained earnings

Examples of Off-Balance Sheet Activities Loan commitments promises to make loans in return for fees Trust services generates fees by holding and managing individuals or corporations assets Correspondent banking generates fees by provision of banking services to other banks

2.3 Trends in Commercial Banks Consolidation Number of Banks 1989 12,709 1993 10,958 1999 8,579 2001 8,080 2004 7,660

Economies of Scale and Scope the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase Economies of scope the degree to which a firm can generate cost synergies by producing multiple financial service products X efficiencies cost savings due to the greater managerial efficiency of the acquiring firm

4. Commercial Banks by Asset Size (2004) Size Range Number % Assets < $100 million 3,755 49.0% $194.6 2.4% $100 million - $1 billion 3,458 45.2% $927.8 11.2% $1 billion - $10 billion 360 4.7% $971.3 11.8% > $10 billion 87 1.1% $6,150.7 74.6% Total Industry 7,660 100.0% $8244.4

Bank Size Classifications Community bank - a small bank that frequently specializes in retail or consumer banking Regional bank - a mid-sized bank that engages in a complete array of wholesale commercial banking activities Super regional bank – a large regional bank – usually does business in more than one state Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds Financial conglomerate – a large bank that does a lot of other financial activities – investment banking, insurance etc.

Bank Size and Activities Large banks have easier access to capital markets and can operate with lower amounts of equity capital Large banks tend to have fewer core deposits Large banks lend to larger corporations which means that their interest rate spread is narrower Large banks are more diversified, have more off-balance-sheet activities and generate more noninterest income

Bank Size and Concentration Wholesale banking provide commercial and industrial loans funded with purchased funds Retail banking provide residential and consumer loans and accepting small deposits

Wholesale Banking Services Controlled disbursement accounts Account reconciliation Lockbox services Electronic lockbox Funds concentration Electronic funds transfer Check deposit services

Wholesale Banking Services (cont..) Electronic initiation of letters of credit Treasury management software Electronic data interchange Facilitate business-to-business e-commerce Electronic billing Verifying identities Assist small business entry in e-commerce

Retail Banking Services Automated teller machines (ATMs) Point-of-sale debit (POS) cards Preauthorized debits/credits Paying bills via telephone On-line banking Smart cards (stored-value cards)

5. Regulators Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks Office of the Comptroller of the Currency (OCC) function is to charter national banks as well as close them has the power to approve/disapprove of mergers Federal Reserve System requires all banks to meet the same noninterest-bearing reserve requirements State Authorities performs for state chartered banks similar functions as the OCC does for national banks