COMMERCIAL BANK OPERATIONS & REGULATION
CHAPTER 13 & 16 COMMERCIAL BANK OPERATIONS & REGULATION
An Overview of the Banking Industry Today
The commercial banking industry is comprised of less than 9,000 banks down from a peak of 15,000 in 1980. Commercial banks' geographic expansion was once limited but these limits have been almost eliminated. Consequently, while the number of banks has declined, the total number of bank branches has grown to over 70,000.
Number of Banks and Branches, 1920-2001, Exhibit 13.1
An Overview of the Banking Industry Today (concluded)
The decline in the number of banks can be attributed to the rapid pace of consolidation in the industry. Large banks dominate asset and deposit holdings in the industry.
Bank Holding Companies
The bank holding company is the major form of organization for banks in the United States and was used: To achieve geographic expansion. To offer traditional nonbanking financial services. To reduce their tax burden. The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act allowed banks to acquire banks in other states.
Bank Holding Companies (concluded)
Bank Holding Companies were first regulated under the Bank Holding Company Act of 1956, with major amendments made in 1970 to include one-bank holding companies under the definition of a bank holding company. There was a concern about concentrated economic power and concern that troubled bank holding companies could undermine the confidence in commercial banks. The Federal Reserve regulates bank holding companies.
Financial Holding Companies
Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley) Extended list of allowable financial activities for Fed certified financial holding companies Insurance underwriting and investment banking
The Largest BHC’s and FHC’s
25 Largest Bank Holding Companies Year End 2002
Bank Failures in the United States
Occur when a bank’s assets are worth less than its liabilities. Deposit insurance was developed to reassure depositors that their deposits were safe even if their bank failed.
Deposit Insurance Deposit insurance was first enacted in 1933 for up to $2,500 per account. Over time the limit increased to $100,000 per account. Currently, deposits are insured up to $100,000 per depositor.
Bank Regulators Bank Insurance Fund (FDIC-1933) and (SAIF-1989)
Insures deposits to $100,000. Examines state chartered, non-Fed member banks and S & L's. Autonomous funding from deposit premiums. Influences all banks by providing deposit insurance.
Bank Regulators (continued)
Federal Reserve System (1913) Examines state chartered, member banks. Autonomous funding--independent. Monetary control authority. Regulates bank and financial holding companies. Comptroller of the Currency (OCC) 1863 Charters national banks; closes failed national banks. Examines national banks.
Bank Regulators (concluded)
State Banking Agencies Charter state banks. Examine state chartered banks. Protect public.
Bank Examinations Are an important part of bank regulation
Bank examinations are intended to promote and maintain safe and sound bank operating practices. The examination procedure includes: bank financial information collected quarterly (call reports). on-site bank examinations. discussion of examination findings with bank management.
Bank Examinations, cont.
Areas of the Bank Analyzed in the Examination Process Capital adequacy. Asset quality. Management competency. Risk Management. Earnings of the bank. Liquidity of the bank.
Bank Sources of Funds -- Liabilities and Capital
Demand deposits accounts Savings Accounts Certificates of Deposit Borrowed Funds from Other Institutions Capital Notes and Bonds Bank Capital Accounts – Equity or Ownership
Uses of Funds -- Bank Assets
Cash assets Federal Funds sold represent excess reserves. Bank investments U.S. Treasury securities offer safety, liquidity, collateral, and income. U.S. government agency securities provide safety and income. Municipal securities provide income and a tax shield.
Bank loans Loans are generally more risky than the investment portfolio. Banks make fixed rate or floating rate loans. Many loans are secured by collateral; others are unsecured.
Commercial and Industrial Loans
Represent the major loan category of banks. Bridge loans -- a business financing agreement with repayment coming from the completion of the agreement. Seasonal loans -- financing of varying working capital needs over a year with repayment coming from the reduction in working capital. Long-term asset loans -- financing equipment over several years with repayment coming from future profits and cash flows of the borrower.
Other Loans Loans to depository institutions -- loans to respondent banks, S&Ls, and foreign banks. Real estate loans -- fixed or variable rate long-term loans residential mortgage loans commercial and industrial real estate loans
Other Loans (concluded)
Consumer loans to individuals most are paid back in installments includes credit card and purchase credit Bank Credit Cards -- credit extended to consumer at the time of purchase and/or cash advance: once local, credit card networks are now worldwide bank earns fees from annual fee, merchant discount and interest on revolving credit balances
The Prime Rate The commercial loan index rate posted by banks.
Traditionally, most loans were tied to the prime rate, but today other market rates such as LIBOR, Treasury or CD rates are used as loan pricing reference rates. The prime rate remains a popular media indicator of changing credit conditions. The prime rate lags or follows market rates.
Base Rate Loan Pricing Most banks use a base rate of interest as a markup base for loan rates. The base rate may be the prime rate, the Federal Funds rate, LIBOR, or the Treasury rate and is expected to cover the following: the cost of funds of the bank. the bank's administrative costs a fair return to the bank shareholders
Base Rate Loan Pricing Factors
An upward adjustment from prime for default risk. An adjustment for term to maturity. An adjustment for competitive factors.
Match-funding Loan Pricing
The loan rate is determined by adding a spread to the deposit cost to cover administrative costs, default risk, and a competitive return to bank shareholders. By matching the maturities of sources and uses, changing market interest rates are less likely to affect bank earnings.
Analysis of Loan Credit Risk: The 5 C’s of Credit
character -- willingness to pay. capacity -- cash flow. capital -- wealth. collateral -- pledged assets. conditions -- current economic conditions.
Fee-Based Services Fee-based services have become important sources of bank revenue. Correspondent banking involves the sale of bank services to other banks and institutions. Bank leasing is an important type of credit service. Trust operations involve the bank acting in a fiduciary capacity for customers.
Fee-Based Services (continued)
Investment products such as brokerage services and mutual funds are relatively new, but increasingly important sources of fee income. Financial Holding Companies—May own insurance underwriting and investment banking companies.
Off-balance Sheet Banking
Off-balance-sheet activities are fee-based activities that give rise to contingent assets and liabilities.
Off-balance Sheet Banking (continued)
Loan commitments – plan ahead Letters of credit Loan brokerage Derivative securities
Securitization Mortgage, auto or credit card loans are pooled together in a trust arrangement. Securities are sold to individual and institutional investors. The cash flow collections from the loans are forwarded to the trust and investors.
The bank earns loan origination fees, perhaps underwriting fees, and loan servicing fees, and the funds raised by the securitization are used to originate more loans. Securitizing loans enables the bank to generate fees without added bank equity capital, required reserves (no funding needed), and deposit insurance premiums.
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