COMMERCIAL BANK OPERATIONS CHAPTER 13 COMMERCIAL BANK OPERATIONS

Bank Uses of Funds: Loans and Leases: The primary business activity of commercial banks. Very profitable to banks. Take time to arrange Subject to greater default risk. Have less liquidity. Copyright© 2006 John Wiley & Sons, Inc.

Bank Uses of Funds: Loans and Leases: Most bank loans consist of promissory notes. Promissory note: unconditional promise made in writing by the borrower to pay the lender a specific amount of money at some specified future date. Repayment can be: Periodically in installments. In total on a single date. On demand. Copyright© 2006 John Wiley & Sons, Inc.

Bank Uses of Funds: Loans and Leases: Banks loans can be: Secured: backed by a security or a collateral ( e.g. merchandise, inventory, plant or stocks) Unsecured. Fixed-rate: interest does not change. Floating-rate: interest is periodically adjusted to changes in a designated short-term interest rate e.g. LIBOR. In periods of stable rates, banks prefer to make long-term fixed rate loans. In periods of volatile rates, banks prefer to make short-term floating rate loans. Copyright© 2006 John Wiley & Sons, Inc.

Major categories of bank loans: Commercial and Industrial Loans. Most are short-term. Three basic types: Bridge loan: supplies cash for a specific transaction with repayment coming from identifiable cash flow. Seasonal loan: provides financing to take care of temporary discrepancies between revenues and expenses. Long-term asset loans: finance the acquisition of assets. Copyright© 2006 John Wiley & Sons, Inc.

Major categories of bank loans: Loans to Depository Institutions. Loans to other banks or savings and loan associations. Usually made by large banks. Real Estate Loans: finance the purchase, construction and remodeling of residential housing and commercial facilities. Agricultural Loans: loans to farmers to finance farming activities. Consumer Loans: short- and long-term loans to individuals. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Lease Financing Fast-growing line of business for large banks The main justification for leasing is taxation (if the lessee “consumer” is in a lower tax bracket than the lessor “bank” becomes a viable alternative to borrowing and purchasing the asset). Banks enter into leasing because the rate of return on leasing activities is comparable to that earned on lending. Common financing technique for— “fleet assets” (aircraft, ships, etc.) “rolling stock” (trucks, rail cars, etc) other capital equipment (cranes, generators, etc.) Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Other Assets Trading account assets: inventory of securities held for resale. Fixed assets: real assets such as land, buildings, equipment, etc. Intangibles: goodwill, pre-paid expenses, etc. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Loan Pricing Loan pricing is one of the most important management decisions made by a bank manager. 3 key considerations: Rate on loan must be high enough to cover costs of funding. Rate on loan must be sufficient to cover administration costs (cost of originating and monitoring the loan). Rate on loan must provide adequate compensation for the credit risk, liquidity risk and interest rate risk. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. The “Prime Rate” The prime rate: Historically served as a benchmark rate or a base rate. Was the lowest loan rate posted by commercial banks Was the rate banks charged their most creditworthy customers and all 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—“London Interbank Offered Rate” Treasury rates Fed Funds rate 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© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Base rate pricing Banks set a base rate for their creditworthy customers and then use this rate as a markup base for all other customers. 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© 2006 John Wiley & Sons, Inc.

Non-price adjustments Banks can also make nonprice adjustments to alter the effective loan rate.The most common of these adjustments are changes in compensating balances. Compensating balances- Bank requires borrower to carry minimum balance in non-interest-bearing deposit account. effective return increases because net loan amount is lower. Example: if a firm borrowed $100,000 for 1 year at an 8% interest rate and requires a 10% compensating balance. What is the minimum balance the firm should maintain in deposit account? What is the effective annual rate of interest? Other nonprice adjustments— Risk reclassification: from lower to higher credit risk classes. Additional collateral or specified collateral Shorter maturities Copyright© 2006 John Wiley & Sons, Inc.

Matched-funding loan pricing A way by which the bank can control the interest rate risk of fixed-rate loan. Fixed-rate loans are funded with deposits or borrowed funds of the same maturity. Example: 1-year fixed-rate loan might be funded with a 1-year CD. Copyright© 2006 John Wiley & Sons, Inc.

Analyzing, managing, and pricing credit risk One of a lending officer’s main tasks is to analyze a customer’s creditworthiness (default risk premium) by using: 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: is an efficient, inexpensive and objective method of analyzing a potential customer’s character. It involves assigning a potential borrower a score based on the information in the borrower’s credit report. Copyright© 2006 John Wiley & Sons, Inc.

Analyzing, managing, and pricing credit risk Factors the determine the score are: 1. Payment history 2. Amount owed 3. Length of credit history 4. Extent of new debt 5. Type of credit in use Advantages of credit scoring: It allows lenders to make very fast loan decisions. A person’s credit scoring is based on objective criteria. Disadvantages of credit scoring: It is impersonal and does not allow for special circumstances. Once the five Cs are analyzed, the customer is assigned to a credit rating category. Each credit rating category has it own default risk premium. Higher credit score indicates lower default risk. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Pricing deposits Deposits are the bank’s main source of loanable funds. Must offer depositors high enough rates to attract and retain a stable deposit base. Must not pay so much on deposits that profitability is compromised. 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 Copyright© 2006 John Wiley & Sons, Inc.