1. COMMERCIAL BANK OPERATIONS
CHAPTER 13
COMMERCIAL BANK OPERATIONS
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2. Overview of the Banking Industry
Fewer banks, more branches
Many small banks, a few very large banks
Holding companies predominate
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3. 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.
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8. 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.
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9. 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
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10. 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
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11. 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.
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12. 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.
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13. 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.
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16. Uses of Funds: Assets Cash Assets Investments Loans & Leases
Other Assets
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17. 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
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18. Investments: Risk discouraged in favor of liquidity
U.S. Treasury securities
Agency securities
Municipal securities
Interest is exempt from federal income tax.
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19. 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
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20. 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.)
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21. 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.
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23. 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
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24. 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
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25. 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
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26. 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
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27. 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
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28. 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
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29. 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.
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31. 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
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32. 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
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33. 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
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34. 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
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35. 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
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36. 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
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37. 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
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38. 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
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39. 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)
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40. Loan brokerage Sale of loans after origination
Restores liquidity and earns fees
Avoids regulatory burden of loans on books
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41. 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
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42. 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
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43. Income Statement for Commercial Banks
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44. Bank Earnings (continued)
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45. Bank Earnings (continued)
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46. Bank Earnings (continued)
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47. 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)
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48. Bank Performance (cont.)
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49. 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
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50. Financial Holding Companies
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