1. Money and Capital Markets 15 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu The Commercial Banking Industry

2.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 2  Learning Objectives   To understand how important commercial banks are to the functioning of a modern economy and financial system.  To explore the makeup of the United States’ banking industry.  To learn about bank financial statements and how to read them.  To see how banks create and destroy money and credit, and why this activity is so vital.

3.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 3 Introduction  The dominant privately owned financial institution in the U.S. and in the economies of most major countries is the commercial bank.  This institution offers the public both deposit and credit services, as well as a growing list of newer and more innovative services, such as investment advice, security underwriting, selling insurance, and financial planning.

4.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 4 The Structure of U.S. Commercial Banking Number Number of Type of Bank of Banks Branch Offices National banks2,23032,808 State-chartered member banks99112,954 Total Fed member banks3,22145,762 Nonmember state-chartered banks 5,09418,317 Total U.S.-insured banks8,31564,079 Number of U.S.-insured Commercial Banks at Year-end 2000 Source: Federal Deposit Insurance Corporation

5. The Structure of U.S. Commercial Banking Source: Board of Governors of the Federal Reserve System 15 - 5

6.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 6 A Trend Toward Consolidation  One of the most important structural changes affecting the banking industry in recent years is the drive toward consolidation of industry assets into fewer, but larger, banking organizations.

7.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 7 Branch Banking  The drive toward consolidation of banks into larger organizations is most evident in the long-term shift toward branch banking.  Many of the nation’s largest banks have followed their customers to distant markets across the nation through branching and mergers, so as to protect their sources of funds and their earnings.

8.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 8 Bank Holding Companies  Paralleling the rapid growth of branch banking has been the growth of bank holding companies – corporations organized to acquire and hold the stock of one or more banks.  Holding companies have become the predominant bank organizational form because of their advantages in raising capital, spreading out their risk exposure, and allowing entry into new business opportunities.

9.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 9 International Banking  Bank expansion into international markets has taken place through a wide variety of organizational forms:  representative offices  branch offices  acquisitions of existing overseas banks, that then become subsidiaries of the international bank  joint ventures with foreign firms

10.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 10 The Convergence Trend in Banking  Another important structural change occurring in banking today is convergence – banking organizations are looking more and more like other financial-service providers, offering many of the same services as security firms, insurance companies, etc.  In the U.S., leading banks are moving toward universal (merchant) banking.

11.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 11 Bank Failures  The rapid expansion of bank services has not protected some banks and banking systems from getting into serious trouble.  Banks have failed due to declining economies, falling real estate and stock prices, bad loans, excessive risk-taking, crime, etc.

12.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 12 Changing Technology  Banking today is also passing through a technological revolution.  Computer networks and high-speed information processing are transforming the industry, stressing convenience and speed in handling such routine transactions as making deposits and paying for purchases.

13.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 13 Portfolio Characteristics of Commercial Banks ASSETS AND LIABILITIES OF FDIC-INSURED COMMERCIAL BANKS (Amounts in Millions of Dollars) 12/31/0012/31/95 Number of institutions.................................................................…8,3159,940 Total assets................................................................................…6,238,7134,312,676 Cash and due from depository institutions ( Primary Reserves ).369,811306,522 Noninterest-bearing...............................................................…264,639227,402 Interest-bearing......................................................................…105,17379,120 Securities ( Secondary Reserves )............................................…1,077,668 810,872 U.S. Treasury securities..........................................................…75,740243 U.S. Government agency and corporation obligations...........…634,65313,610 Securities issued by states and political subdivisions............…92,625841 Other domestic debt securities...............................................…171,931 1,168 Foreign debt securities...........................................................…61,5754 Equity securities.....................................................................…41,145778 Investments in mutual funds................................................…13,83198 Other equity securities.........................................................…27,314680 Federal funds sold & securities bought under resell agreements280,116180,843 Source: Federal Deposit Insurance Corporation

14. Portfolio Characteristics of Commercial Banks ASSETS AND LIABILITIES OF FDIC-INSURED COMMERCIAL BANKS … continued 12/31/0012/31/95 Loans and leases, net..............................................................…3,752,1382,550,125 Plus: allowance for losses and allocated transfer risk reserve..64,05452,838 Loans and leases, total........................................................…3,816,1912,602,963 Plus: unearned income......................................................…2,9155,853 Loans and leases, gross...................................................…3,819,1072,608,816 Loans secured by real estate, total..............................…1,670,2781,080,116 Construction and land development........................…162,13168,696 Secured by farmland................................................…34,04023,907 Secured by 1-4 family residential properties............…916,383625,990 Secured by multifamily residential properties...........…60,17835,788 Secured by nonfarm nonresidential properties............465,512298,533 Loans to depository institutions....................................…120,45886,972 Loans for agricultural production & other farm loans........48,07840,180 Commercial and industrial loans.......................................1,048,248661,417 Loans to individuals......................................................…609,713535,348 Other loans....................................................................…155,651147,279 Lease financing receivables.............................................166,68157,503 Assets held in trading accounts...............................................…304,249217,179 Bank premises and fixed assets...................................................75,70161,425 Other real estate owned..........................................................…3,1986,644 Intangible assets......................................................................…102,70330,218 All other assets.........................................................................… 273,130148,850

15. Portfolio Characteristics of Commercial Banks ASSETS AND LIABILITIES OF FDIC-INSURED COMMERCIAL BANKS … continued 12/31/0012/31/95 Total liabilities, limited-life preferred stock, and equity capital.......6,238,7134,312,676 Total liabilities..........................................................................…5,709,1303,963,106 Deposits, total........................................................................…4,176,5753,027,574 Noninterest-bearing.............................................................…765,893611,986 Foreign offices...................................................................…40,55118,380 Interest-bearing...................................................................…3,410,6822,415,589 Foreign offices...................................................................…666,115435,714 Deposits, domestic offices: Total.................................................................................…3,469,9082,573,480 Demand deposits...........................................................…531,400576,709 Savings deposits............................................................…1,566,9921,030,048 Time deposits................................................................…1,371,516966,723 Memoranda: Time CDs of $100,000 or more.....................................…575,173267,480 Estimated insured deposits............................................…2,398,4231,958,944 Source: Federal Deposit Insurance Corporation15 - 15

16. Portfolio Characteristics of Commercial Banks Source: Federal Deposit Insurance Corporation15 - 16 ASSETS AND LIABILITIES OF FDIC-INSURED COMMERCIAL BANKS … continued 12/31/0012/31/95 (Nondeposit Sources of Funds) Federal funds purchased and securities sold under agreements to repurchase................................................…475,182326,506 Demand notes issued to the U.S. Treasury...........................…14,21011,870 Trading liabilities....................................................................…211,663143,161 Other borrowed money...........................................................…555,102288,636 Subordinated notes and debenture........................................…87,04343,536 All other liabilities...................................................................…189,356121,819 Total equity capital...................................................................…529,583349,571 Perpetual preferred stock.......................................................…3,3771,835 Common stock.......................................................................…31,24935,883 Surplus..................................................................................…259,409146,781 Undivided profits....................................................................... 236,867166,067 Cumulative foreign currency translation adjustments............... (1,319)(995) Memoranda: Loans and leases past due 30-89 days.................................…47,93633,689 Loans and leases past due 90 or more days.........................…10,8908,096 Loans and leases in nonaccrual status.................................…32,02122,254 Income earned, not collected on loans.................................…32,12720,249 Total assets in foreign offices................................................…759,871585,096

17.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 17 Portfolio Characteristics of Commercial Banks INCOME AND EXPENSE OF FDIC-INSURED COMMERCIAL BANKS (Amounts in Millions of Dollars) 2000 1995 Number of institutions................................................................…8,3159,940 Number of employees (full-time equivalent)..............................…1,662,3351,484,421 Total interest and fee income....................................................... 427,985302,383 Domestic office loans.............................................................…294,837200,106 Foreign office loans................................................................…24,53323,349 Lease financing receivables...................................................…10,7813,705 Balances due from depository institutions..............................…6,4416,147 Investment securities..............................................................…68,45651,213 Assets held in trading accounts..............................................…9,4248,244 Federal funds sold & securities bought under resell agreements13,5139,618 Source: Federal Deposit Insurance Corporation

18. Portfolio Characteristics of Commercial Banks Source: Federal Deposit Insurance Corporation15 - 18 INCOME AND EXPENSE OF FDIC-INSURED COMMERCIAL BANKS … continued 2000 1995 Total interest expense...............................................................…224,195148,173 Domestic office deposits.........................................................…114,93079,404 Foreign office deposits............................................................…36,73625,977 Federal funds purchased and securities sold under agreements to repurchase.................................................…27,43618,548 Demand notes issued to the U.S. Treasury & other loans.........39,17121,050 Subordinated notes and debentures......................................…5,9223,193 Net interest income....................................................................…203,790154,210 Provisions for credit losses and allocated transfer risk.............…29,25412,603 Total noninterest income...........................................................…152,75182,426 Fiduciary activities..................................................................…21,37012,304 Service charges on deposit accounts.....................................…23,77816,046 Trading account gains and fees.............................................…12,4446,333 Foreign exchange exposures.............................................…5,0892,491 All other noninterest income...................................................…95,15947,743 Total noninterest expense........................................................…215,753149,729 Salaries and employee benefits............................................…88,50763,440 Premises and equipment......................................................…26,76519,618 All other noninterest expense...............................................…100,48166,670

19. Portfolio Characteristics of Commercial Banks Source: Federal Deposit Insurance Corporation15 - 19 INCOME AND EXPENSE OF FDIC-INSURED COMMERCIAL BANKS … continued 2000 1995 Pre-tax net operating income....................................................…111,53474,304 Gains (losses) on securities not held in trading accounts.........…(2,285)541 Applicable income taxes...........................................................…38,04326,125 Income before extraordinary items............................................…71,20648,720 Extraordinary items, net............................................................…(30)26 Net income.................................................................................…71,17648,745 Net loan and lease charge-offs.................................................…23,61312,202 Total loan and lease charge-offs............................................…29,25418,204 Total loan and lease recoveries.............................................…5,6416,002 Cash dividends declared..........................................................…53,79831,053 Cash dividends declared on preferred stock.........................…105202 Cash dividends declared on common stock..........................…53,69330,851 Net additions to capital stock....................................................…4,3042,449

20.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 20 Money Creation and Destruction by Banks  Banks have the power to create money in the form of new checkable deposits, credit card lines, debit cards, and other immediately spendable funds.  As a whole, the banking system can create a volume of money equal to a multiple of any excess reserves deposited with it simply by making loans and purchasing securities.

21.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 21 Reserve Requirements and Excess Reserves  Vault cash and deposits at the Fed constitute a bank’s holdings of legal reserves – those assets acceptable for meeting legal reserve requirements behind the public’s deposits.  Each bank’s legal reserves may be divided into two categories: required reserves and excess reserves.

22.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 22 The Creation of Money and Credit  The distinction between excess and required reserves is important because it plays a key role in the growth of credit in the economy and the creation of money by the banking system.  By making loans whenever excess reserves appear, the banking system eventually creates total deposits and total loans several times larger than the original volume of new funds received.

23.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 23 The Creation of Money and Credit  The maximum total deposits created by the banking system is equal to the initial amount of legal reserves deposited in the system times the deposit multiplier (the reciprocal of the reserve requirement ratio).

24.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 24 Destruction of Deposits and Reserves  Similarly, the money supply can contract by a multiple amount when legal reserves are withdrawn from the banking system.

25.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 25 Implications of Money Creation and Destruction  Creation of money by banks is one of the most important sources of credit funds in the global economy.  However, money created by banks is instantly available for spending, and therefore, unless carefully controlled by government action, the creation of money can fuel inflation.

26.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 26 Money and Capital Markets in Cyberspace  More information about the commercial banking industry can be found at:  http://www.federalreserve.gov http://www.federalreserve.gov  http://www.occ.treas.gov/ http://www.occ.treas.gov/  http://www.fdic.gov/ http://www.fdic.gov/  http://www.pueblo.gsa.gov/ http://www.pueblo.gsa.gov/  http://www.bankstaffers.com/ http://www.bankstaffers.com/  http://www.ffiec.gov/ http://www.ffiec.gov/

27.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 27 Chapter Review  Introduction  The Structure of U.S. Commercial Banking  A Trend Toward Consolidation  Branch Banking  Bank Holding Companies  International Banking  The Convergence Trend in Banking  Bank Failures  Changing Technology

28.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 28 Chapter Review  Portfolio Characteristics of Commercial Banks  Cash and Due from Banks (Primary Reserves)  Security Holdings and Secondary Reserves  Loans  Deposits  Nondeposit Sources of Funds  Equity Capital  Revenues and Expenses

29.  2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 15 - 29 Chapter Review  Money Creation and Destruction by Banks  Reserve Requirements and Excess Reserves  The Creation of Money and Credit  Destruction of Deposits and Reserves  Implications of Money Creation and Destruction