Financial Markets and Institutions 6th Edition PowerPoint Slides for: Financial Markets and Institutions 6th Edition By Jeff Madura Prepared by David R. Durst The University of Akron

Commercial Bank Operations 17

Chapter Objectives Describe the most common sources of funds for commercial banks Describe the most common uses of funds for commercial banks Describe typical off-balance sheet activities for commercial banks

Bank Participation in Financial Conglomerates Impact of the Financial Services Modernization Act (1999) Prompted by the Citicorp-Traveler’s merger Banks and other financial service firms were given more freedom to merge and offer a range of financial services Insurance Securities services Banks now a subsidiary of financial conglomerates

Bank Participation in Financial Conglomerates Benefits of diversified services to individuals and firms Individuals can obtain all their financial services at a single financial conglomerate Deposits Loans Investing (brokerage) Insurance Businesses can obtain loans, issue stocks and bonds, and have their pension fund managed by the same institution

Bank Participation in Financial Conglomerates Benefits of diversified services to the financial institution Reduce reliance on demand for single service Economies of scale and scope Diversification (service and geographical) may result in less risk Generate new business

Bank Sources of Funds Transaction deposits Savings Deposits Demand deposit account (checking) Negotiable order of withdrawal (NOW) account 1981 Requires larger minimum balance Savings Deposits Passbook savings Regulation Q until 1986

Bank Sources of Funds Time Deposits Certificate of deposit (CD) No secondary market Negotiable CD Short-term, minimum $100,000 Can trade among investors via dealer Money Market Deposit Accounts (MMDAs) More liquid than CDs : no specified maturity Limited check writing Created in 1982

Bank Sources of Funds Federal Funds Purchased Short-term loans between banks Allows banks to meet reserve requirement or funding needs Interest rate charged is the federal funds rate Borrowing from the Federal Reserve Banks Borrowing at the discount window Discount rate Intended for meeting temporary short-term reserve requirement needs Must get Fed approval

Bank Sources of Funds Repurchase agreements Sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price Banks may sell T-bills to a corporation with temporary excess cash (bank demand deposit) and then buy them back later Source of funds for a few days Collateralized by the treasury bills Form of paying interest on large customer checking balances

Bank Sources of Funds Eurodollar borrowings Bonds issued by the bank Banks outside the United States make dollar-denominated loans Eurodollar market is very large Bonds issued by the bank Like other businesses, banks issue bonds to finance long-term fixed assets Usually subordinated to deposits Part of secondary regulatory capital

Bank Sources of Funds Bank capital Obtained from issuing stock or retaining earnings No obligation to pay out funds in the future Primary vs. secondary Must be sufficient to absorb operating losses As of 1992: risk-based capital requirement

Uses of Funds by Banks Loans make up about 64 percent of bank assets, while all securities make up about 22 percent of assets. Cash represents 6 percent of bank assets. Cash and “due from” balances at institutions Currency/coin provided via banks Reserve requirements imposed by Fed Tool for controlling the money supply Due from Fed and vault cash count as reserves Also hold cash and due from balances to maintain liquidity and accommodate withdrawal requests by depositors

Uses of Funds by Banks Bank Loans Types of business loans Working capital loans Term loans Purchasing fixed assets Protective covenants Informal line of credit Revolving credit loan

Uses of Funds by Banks Bank Loans Loan participations Sometimes large firms seek to borrow more money than an individual bank can provide Lead bank Loans supporting leveraged buyouts Banks charge a high loan rate Monitored by bank regulators

Uses of Funds by Banks Bank Loans Collateral requirements on business loans Increasingly accepting intangible assets Important to service-oriented firms Increased lending risk with service businesses--telecomm Lender liability on business loans Lender liability lawsuits—toxic dump under corner business Types of consumer loans Installment loans Credit cards Real estate loans

Uses of Funds by Banks Investment securities (bank income and liquidity) Treasury securities Government agency securities Freddie Mac Fannie Mae Corporate and municipal securities Investment grade only Federal funds sold Lending funds in the federal funds market

Uses of Funds by Banks Repurchase agreements Eurodollar loans Branches of U.S. banks located outside of the U.S. Foreign-owned banks Fixed assets Office buildings Land

Off-Balance Sheet Activities Loan commitments Obligation of bank to provide a specified loan amount to a particular business upon request Note issuance facility (NIF) Banks earn fee income for risk assumed Standby letters of credit (SLC) Backs a customer’s obligation to a third party Banks earn fee income

Off-Balance Sheet Activities Forward contracts Agreement between a customer and bank to exchange one currency for another on a particular future date at a specified exchange rate Allows customers to hedge their exchange-rate risk

Off-Balance Sheet Activities Swap contracts Two parties agree to periodically exchange interest payments on a specified notional amount of principal Banks serve as intermediaries or dealer and/or guarantor for a fee