Commercial Banks: Industry Overview

Commercial Banks / Depository Institutions

 Commercial banks are the largest group of financial institutions in terms of total assets
 Major assets are loans
 Major liabilities are deposits—thus, they are considered depository institutions
 Perform services essential to financial markets
o play a key role in the transmission of monetary policy
o provide payment services
o provide maturity intermediation
 Banks are regulated to protect against disruptions to the services they perform

Commercial Bank Assets

 Loans in 4 broad classes:

1. business or commercial and industrial loans;
2. commercial and residential real estate loans;
3. individual loans (for auto purchases and credit card loans)
4. all other loans (like the loans to emerging market countries)

 Loans generate revenue for banks

o commercial and industrial loans are declining because of nonbank substitutes such as
commercial paper
o mortgages are increasing in importance
 Investment securities generate revenue and provide banks with liquidity (interest bearing deposits
purchased from other Fıs, Fed Funds sold to other banks, RePOs, Treasury securities, municipal
securities, mortgage backed securities and other debts and securities)
 Cash assets are held to meet reserve requirements and to provide liquidity
 Other assets include premises and equipment, other real estate owned, etc.

Commercial banks face unique risks because of their asset structure

 credit (default) risk is the risk that loans are not repaid
 liquidity risk is the risk that depositors will demand more cash than banks can immediately
provide
 interest rate risk is the risk that interest rate changes erode net worth
 credit, liquidity, and interest rate risk all contribute to a commercial bank’s level of insolvency
risk

Commercial Bank Liabilities = deposits + borrowed or other liability funds+owner

  Transaction accounts are the sum of noninterest-bearing demand deposits and interest-bearing
checking accounts
o interest bearing deposit accounts are called negotiable order of withdrawal (NOW) accounts
 Household (retail) savings and time deposits
 A savings account is an interest-bearing deposit account held at a bank or another financial
institution that provides a modest interest rate. Banks or financial institutions may limit the
number of withdrawals you can make from your savings account each month
 Large time deposits
 Mainly negotiable CDs which are fixed-maturity interest-bearing deposits with face values of
$100,000 or more that can be resold in the secondary market.

Commercial Bank Liabilities & Equity

 Non-deposit liabilities
1. Fed funds purchased
2. Repos (seller)
3. Notes and bonds (seller)
 Minimum levels of equity capital are required by regulators to act as a buffer against losses
- common and preferred stock
- surplus or additional paid-in capital
- retained earnings

Off-Balance-Sheet Activities

 The balance sheet itself does not reflect the total scope of bank activities.
 Under current accounting standards, such activities are not shown on the current balance sheet.
 Off balance sheet asset or liability will we a part of asset or liability after an activity or event occurs.
 Banks’ intention is to earn fee income and avoid regulatory “tax avoidance” as these activities do
have tax avoidance incentives.
 Off-balance-sheet asset: when an event occurs, this item moves onto the asset side of the balance
sheet or income is realized on the income statement
 Off-balance-sheet liability: when an event occurs, this item moves onto the liability side of the
balance sheet or an expense is realized on the income statement

Size, Structure and Composition of the Industry: Commercial Banks

 The number of banks in the USA is decreasing: 6,676 banks in 2010.

- 14,483 banks with some 60,000 branches in 1984
- 7,350 banks with some 83,000 branches in 2007
- Strict regulations imposed on commercial banks limited geographical diversification
opportunities.

Commercial Banks Bank Size and Concentration

 Retail banking /community banks (small or community banks with less than 1 billion in asset size)
and specializes in retail or consumer banking.
- They provide residential and consumer loans and accepting smaller deposits.
 Large banks in terms of their assets size are called:
 Wholesale banking is commerce-oriented
- commercial and industrial loans are often funded with purchased funds
- Some of the very biggest banks are classified as being:
- money center banks that rely heavily on no deposit or borrowed sources of funds often
borrowed in the federal funds market
- Federal fund market: an interbank market for short term borrowing and lending of bank
reserves
- Money center banks are also major participants in foreign currency markets and are therefore
subject to foreign exchange risk

Commercial Banks Bank Size and Concentration

- It is important to note that asset or lending size does not necessarily make a bank a
money center bank.
- Classification as a money center bank is based in part on:

* location of the bank. Specifically, a money center bank is a bank located in a major financial
center (e.g., New York)

*the bank’s heavy reliance on non-deposit or borrowed sources of funds that heavily relies on
both national and international money markets for its source of funds

Main differences between small banks and large banks:

- small banks generally hold fewer off-balance-sheet assets and liabilities than large banks.
- large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits
than small banks
- large banks lend to larger corporations which means that interest rate spreads and net interest
margins are usually narrower than those of smaller banks because the risk is lower in large
corporation than small businesses.
- interest rate spread is the difference between lending and deposit rates
- Large banks tend to pay higher salaries and invest more in buildings and premises than small banks
- Large banks tend to diversify their operations more than small banks.

Regulators FDIC+OCC+FRS+State Authorities

 The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks
 The U.S. has a dual banking system: national banks / state banks
 banks can be either nationally or state chartered
- the Office of the Comptroller of the Currency (OCC) charters and regulates national banks
- state agencies charter and regulate state banks
 The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their
holding companies and state banks who are members of the Federal Reserve System

International Commercial Banking Advantages

1. risk diversification - diversify the risk of its earnings flows.

2. economies of scale - lower its average operating costs by expanding its activities beyond
domestic boundaries.
3. distribute new product innovations internationally
4. opportunity to find the cheapest and most available sources of funds
5. regulatory avoidance - such as activity restrictions and reserve requirements or taxes impose
constraints, with globalization they can operate in low-regulatory, low-tax countries.

International Commercial Banking Disadvantages

 information and monitoring costs are generally higher in foreign markets

Commercial Banks’ Financial Statements and Analysis

Evaluate Performance of Commercial Banks (CBs)

 CBs are unique in

- the special services they perform (e.g., assistance in the implementation of monetary policy)
- the level of regulatory attention they receive
- the types of assets and liabilities they hold

 Managers, stockholder, depositors, regulators, and other parties use performance, earnings, and
other measures obtained from financial statements to be valuate which CB stocks they will purchase

Financial Statements of Commercial Banks

 Report of condition - balance sheet of a commercial bank reporting information at a single point in
time
 Report of income - income statement of a commercial bank reporting revenues, expenses, net profit
or loss, and cash dividends over a period of time
 Retail bank - focuses on consumer banking relationships
 Wholesale bank - focuses on commercial banking relationships

Balance Sheet: Assets

 Four major subcategories

 - cash and balances due from other depository institutions
- vault cash, deposits at the Federal Reserve, deposits at other FIs, and cash items in the
process of collection
- investment securities
- interest-bearing deposits at other FIs, fed funds sold, RPs, U.S. Treasury and agency
securities, securities issued by states and political subdivisions, mortgage-backed securities,
and other debt and equity securities
- loans and leases
- other assets
o premises and fixed assets, real estate owned, investments in unconsolidated
subsidiaries, intangible assets, other fees receivable

Liabilities

o NOW account - negotiable order of withdrawal account, similar to a demand deposit

with minimum balance
o MMDAs - money market deposit accounts with retail msavings accounts and limited
checking account
o Other savings deposits - other than MMDAs
o Retail CDs - time deposits with face value below $100,000
o Wholesale CDs - time deposits with face value above $100,000

o Negotiable instrument - an instrument whose ownership can be transferred in the

secondary market
o Brokered deposits - wholesale CDs obtained through a brokerage house
o Core deposits - deposits of the bank that are stable over short periods of time and thus
provide a long-term funding source to a bank
o Purchased funds - rate-sensitive funding sources of the bank

Equity Capital

o Preferred and common stock (listed at par value)

o Surplus or additional paid-in capital
o Retained earnings
o Regulations require banks to hold a minimum level of equity capital to act as a buffer against
losses from their on- and off-balance sheet assets

Off-Balance-Sheet Assets and Liabilities

o Contingent assets and liabilities that may affect the future status of the FIs balance sheet
 o OBS activities grouped into 5 major categories

- Loan commitments - contractual commitment to loan to a firm a certain maximum amount at

given interest rate terms
o up-front fee - fee charged for making funds available through a loan commitment
o back-end fee - fee charged on the unused component of a loan commitment

o Commercial and Standby Letters of Credit

o letters of credit - contingent guarantees sold by an FI to underwrite the trade or
commercial performance of the buyer of the guarantee
o standby letter of credit - guarantees issued to cover contingencies that are
potentially more sever and less predictable than contingencies covered under
trade-related or commercial letters of credit
o Forward Purchases and Sales of When-Issued Securities
o when-issued securities - commitments to buy or sell securities before they are
issued
o Loans Sold
o loans that a bank originated and then sold to other investors that may be
returned (with recourse) to the originating institution in the future
o recourse - the ability to put an asset or loan back to the seller should the credit
quality of that asset deteriorate
o Derivative Contracts
o futures, forward, swap, and option positions taken by the FI for hedging or other
purposes

Income Statement

o Interest Income
o Interest Expenses
o Net Interest Income
o Provision for Loan Losses
o Noninterest Income
o Noninterest Expense
o Income before Taxes and Extraordinary Items
o Income Taxes
o Extraordinary Items
o Net Income

The Direct Relationship between the Income Statement and the Balance
 NI = ∑ rnAn - ∑ rmLm - P + NII - NIE – T

where

NI = Bank’s net income

An = Dollar value of the bank’s nth asset

Lm = Dollar value of the bank’s mth liability

rn = Rate earned on the bank’s nth asset

rm = Rate paid on the bank’s mth liability

P = Provision for loan losses

NII = noninterest income earned, including OBS

NIE = noninterest expenses incurred

T = Bank’s taxes

N = number of assets the bank holds

M = number of liabilities the bank holds

Financial Statement Analysis Using a Return on Equity Framework

o Time series analysis - analysis of financial statements over a period of time

o Cross-sectional analysis - analysis of financial statements comparing one firm with others
o Return on equity (ROE) - measures overall profitability of the FI per dollar of equity

ROE = Net income × Total Assets

Total Assets Total equity capital

= ROA × EM

Return on Assets and Its Components

Return on Assets (ROA) - measures profit generated relative to the FI’s assets

ROA = Net Income × Total operating income

Total operating income Total assets

= PM × AU

Profit Margin
Profit Margin (PM) - measures a bank’s ability to pay expenses and generate net income from interest
and noninterest income

Interest expense ratio = Interest expense/Total operating income

Provision for loan loss ration = Provision for loan losses/Total operating income

Noninterest expense ratio = Noninterest expense/Total operating income

Tax Ratio = Income taxes/Total operating income

Asset Utilization

Asset utilization (AU) - measures the amount of interest/ noninterest income generated per dollar of
total assets

AU = Total operating income/ Total assets = Interest income ratio

+ Noninterest income ratio

Net Interest Margin

Net interest margin - interest income minus interest expense divided by earning assets

Net interest margin = Net interest income/ Earning assets

= Interest income - Interest expense

Investment securities + Net loans and leases
Spread - the difference between lending and deposit rates

spread = Interest income - Interest expense

Earning assets Interest-bearing liabilities
Overhead efficiency - a bank’s ability to generate noninterest income to cover noninterest expenses

Overhead efficiency = Noninterest income/Noninterest expense

Regulation of Commercial Banks

Commercial Banks

o Commercial banks provide many unique services

o information, liquidity, price-risk reduction, transaction cost, maturity intermediation,
and payment services
 o money supply transmission, credit allocation, intergenerational wealth transfers, and
denomination intermediation

o Failure to provide these services can be costly to both users and suppliers of funds
o Accordingly, commercial banks are regulated at the federal (and sometimes state) level

- Safety and soundness regulation

- assets must be diversified: cannot make loans greater than 10% of their equity capital to
any one borrower
- must maintain adequate equity capital levels to protect against insolvency risk
- provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects
depositors in the event of default and prevents bank runs
- monitoring and surveillance: banks must submit (publicly accessible) quarterly reports
and are subject to on-site examinations

Monetary policy regulation

- the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e.,
outside money) in the economy
- however, the bulk of the money supply is held as bank deposits, called inside money
- regulators require cash reserves to be held at commercial banks

Credit allocation regulation

- regulators encourage (and often require) lending to socially important sectors of the economy
(e.g.,

housing and farming) usury laws cap interest rates that can be charged on loans

Investor protection regulation

- protects investors against insider trading, lack of disclosure, malfeasance, and breach of
fiduciary responsibility

Entry and chartering regulation

- the entry of commercial banks is regulated

- the permissible activities of commercial banks are defined by regulators
- the barriers to entry and the scope of permissible activities allowed affects the charter values of
banks and the size of the net regulatory burden

The net regulatory burden is the difference between the costs of regulations and the benefits for the
producers of financial services
Regulators

- the Federal Deposit Insurance Corporation (FDIC)

- the Office of the Comptroller of the Currency (OCC)
- the Federal Reserve System (FRS)
- state agencies

The four facets of regulatory structure

- regulation of product and geographic expansion

- provision and regulation of deposit insurance
- balance sheet regulation
- off-balance-sheet regulation

Commercial banking vs. investment banking

- commercial banking involves deposit taking and lending

- investment banking involves underwriting, issuing, and distributing securities
- the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment
banks
- by 1987 commercial banks were allowed to engage in limited investment banking activity
through Section 20 affiliates
- the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall

Product SegmCHentation Regulation

Commercial banking vs. insurance underwriting

- the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or
being affiliated with commercial banks
- the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates
and also allows insurance companies to open banks

Commercial banks and commerce

- the BHCA of 1956 restricts commercial firms from nacquiring banks

- the 1970 Amendment to the BHCA requires banks tom divest nonbank related subsidiaries

Geographic Expansion Regulation

Restrictions on intrastate banking

most banks used to be unit banks—i.e., banks with

single offices

by 1997 only six states restricted intrastate branching

Restrictions on interstate banking

the McFadden Act of 1927 (amended in 1933)

restricted national banks from branching across state

lines

as a result, the largest banks were set up as multibank

holding companies (MBHCs)

an MBHC is a parent banking organization that owns a

number of individual bank subsidiaries

OTHER LENDING INSTITUTIONS

- Savings Associations • Historically referred to as savings and loan (S&L) associations

- Savings Banks • Established as mutual organizations and largely confined to the East Coast and New
England states
- Credit Unions • Are not-for-profit depository institutions mutually organized and owned by their
members (depositors)
- Finance Company Functions • Originated during the Depression when General Electric Corp. created
GE Capital Corp. to finance appliance sales to cash-strapped customers • In the late 1950’s, banks
became more willing to make installment loans so finance companies branched out into leasing and
leveraged buyouts • Willing to lend to riskier borrowers • Often are directly affiliated with
manufacturing

INSURANCE COMPANIES
The primary function of insurance companies is to compensate policyholders if a prespecified event
occurs, in exchange for premiums paid insurance underwriters assess and price risk insurance brokers
sell insurance contracts for coverage or for a policy Insurance is broadly classified into two groups life
insurance provides protection against untimely death, illness, and retirement property-casualty
insurance protects against personal injury and liability Insurance companies also sell a variety of
investmentproducts similar to other FIs

SECURITIES FIRMS AND

INVESTMENT BANKS

Investment Banks - raise the debt and equity securities for corporations or governments including the
origination, underwriting, and placement of securities in money and capital markets

• Securities Firms - services involve assistance in the trading of securities in the secondary markets
(brokerage services or market making)

• The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and
are generally called investment banks • advise corporations on mergers and acquisitions as well as
advising on the restructuring of existing corporations

INVESTMENT COMPANIES

- Financial intermediaries that invest the funds of individual investors in securities or other assets.
- Three main types of Investment Companies • Open-end Investment company • Closed-end
Investment company • Unit Investment Trust
- Open-end Investment Company • Sell shares to investors. When the investors want to sell their
shares, the Mutual Fund will repurchases the shares at the NAV. (Funds Grow and Shrink)
- Closed-end Investment Company • Shares more closely resemble stocks in the way that they are
traded. • They raise money only once. The shares are traded on an exchange (like NYSE). • Price
of the shares are influenced by supply and demand AND changes in the value of the holdings
(Stocks and Bonds). • Shares prices may be different than the NAV.
- Unit Investment Trust • Money invested in a portfolio that is fixed for the life of the fund. •
Typically a broker buys a portfolio of securities which are deposited into the trust. It then sells
shares or units in the trust called, redeemable trust certificates. • Most unit trusts hold fixed-
income securities and their unit expires at maturity • Shares or “units” of redeemable trust
certificates are sold by the trust • Investors can sell their shares back to the trustee

PENSION FUNDS

Pension funds offer tax-deferred savings plans • First established in 1759 • American Express
established the first corporate pension fund in 1875 • By 1940, only 400 pensions funds were in
existence • Currently there are over 700,000 pension funds; 30.9% of household fin. assets are in
pension funds
 Pension Funds, Two Distinct Sectors • Private pension funds • funds administered by a private
corporation (e.g., insurance company, mutual fund) • Public pension funds • funds administered by a
federal, state, or local government (e.g., Social Security)