1 Chapter 9 Commercial Banking ©Thomson/South-Western 2006

2 The Importance of Commercial Banks  Commercial banks dominate among depository institutions.  Banks take in funds by accepting checking, saving, and time deposits, and use the funds mainly to grant loans to homebuyers, businesses, and consumers.  Commercial banks are the oldest and most diversified of all financial intermediaries.  In 2005, commercial banks had some $8 trillion in total assets- -more than 75 percent of the total assets of all depository institutions.  Banks are also important in the money supply process.

3 The Commercial Bank Balance Sheet  Banks earn a profit on the “spread” (3%-4%) by obtaining funds at relatively low interest rates and lending at higher interest rates.  In recent years, fees have played an increasingly important role in bank profits.  A bank balance sheet is a statement of its assets, liabilities, and net worth at a given point in time.  Assets are what it owns.  Liabilities are what it owes.  Net worth (capital accounts, capital) is the difference between its assets and liabilities.  Assets - Liabilities = Net Worth  Assets = Liabilities + Net Worth

4 Figure 9-1

5 Table 9-1

6 Commercial Bank Liabilities  Transactions Deposits (checkable deposits)  Demand Deposits: non-interest bearing checking accounts  Negotiable Order Of Withdrawal (NOW) Accounts: interest-bearing checking accounts  Automatic Transfer Service (ATS) Accounts:Paired accounts with checks on non-interest baring accounts and automatic transfers to it from interest-bearing accounts  Non-Transactions Deposits  Passbook Savings Accounts  Small Certificates of Deposit (CDs up to $100,000)  Money Market Deposit Accounts (MMDAs)  Negotiable CDs. Large CDs over $100,000  Non-deposit Borrowing  Borrowing from the Fed at the discount rate  Borrowing from other banks at the federal funds rate

7 Figure 9-2

8 Commercial Bank Assets  Cash Assets: legal reserves as dictated by reserve requirements or required reserve ratios  Loans  Real Estate Loans: collateralized by property, securitized or packaged collections of loans  Business Loans: regular installment loans, lines of credit  Consumer Loans: auto loans, credit cards  Other Loans: federal funds sold  Securities  Building, Land, and Equipment

9 Figure 9-3

10 Commercial Bank Capital Accounts  Bank capital derives from the issue of bank stock shares and from retained earnings.  In 2004, aggregate capital accounts of all U.S. commercial banks were 8.2 % of total bank assets.  Bank capital provides a cushion that protects a bank's owners from potential bank insolvency.

11 Writing Off Bad Loans

12 Commercial Bank Management  Commercial banks strive to:  earn solid profits;  maintain extremely low exposure to the possibility of becoming insolvent, and  maintain high liquidity (the ability to immediately meet currency withdrawals while abiding by existing reserve requirements) by managing liquidity and capital.

13 T-Accounts  T-accounts are statements of the change in the balance sheet resulting from a given event.  ie. if a customer withdraws $200 in cash from a savings account at the Bank of Medicine Bow, Wyoming.  ie. Clearing a check for $12,000 written by a bank customer

14 The Importance of Liquidity  Banks must have emergency plans to meet large reserve withdrawals, so banks need to hold liquid assets like Treasury bills.  If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account.  Banks that exhibit higher risk need larger capital accounts.

15 The Liquidity-Risk Trade-off  With a reserve requirement of 10%, the bank has no excess reserves.  Its assets are 90% in high return loans and 10% in low return securities.  If depositors withdraw $20 million, then the balance sheet changes and the bank must come up with $18 million, of which only $10 million is liquid.

16 The Liquidity-Profitability Trade-off  The bank has $10 million excess reserves.  Its assets are split between high return loans and low return securities.  If depositors withdraw $20 million, then the balance sheet changes and the bank must come up with $8 million, but its assets are so liquid that this is no problem.  It is less profitable because it has fewer high-risk, high-return loans on equity for bank owners.

17 Indicators of Bank Liquidity  The ratio of bank loans to total assets  35% in 1950s vs 60% in 2004  The ratio of securities to total assets  40% in 1950s vs 15% today  The ratio of demand deposit to total bank deposits  60% in 1960 vs 10% today

18 Liability Management  Banks look for good lending opportunities and then search for the funds to finance these loans.  When a large bank finds a profitable lending opportunity, it can:  “buy” federal funds;  issue negotiable CDs at whatever interest rate is required to attract funds;  issue repurchase agreements or borrow Eurodollars, or  obtain funds through the commercial paper market.  Aggressive liability management allows banks to make profitable loans that they would otherwise have to turn down.  Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities. If interest rates rise sharply, banks can suffer severe losses.

19 Capital Management  Bank capital provides a financial cushion so that transitory adverse developments will not cause insolvency.  Bank capital also protects bank managers and owners from their own mistakes and from various risks:  default risk,  interest-rate risk,  liquidity risk,  political or country risk, and  management risk.  Given other factors, a higher bank capital ratio (capital/assets) implies a lower risk of insolvency, but also a lower rate of return.

20 The Capital Management Tradeoff  Earnings/Capital = Earnings/Total assets x Total assets/Capital  The left-hand side of the expression is the rate of return on equity, or rate of return on capital  The first expression on the right-hand side is the rate of return on total assets.  The final expression is the equity multiplier: the amount of leverage that is applied to the rate of return on total assets. A high capital/assets ratio represents a low equity multiplier; a low capital/assets ratio implies a high equity multiplier.  A trade-off arises between short-run profitability and the risk of insolvency.

21 Figure 9-4