Chapter 17

Commercial Bank Operations

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Commercial banks as financial intermediaries Bank market structure Bank sources of funds Uses of funds by banks Off-balance sheet activities International banking

Commercial Banks as Financial Intermediaries

Commercial banks serve all types of surplus and deficit units

Offer

deposit accounts with the size and maturity characteristics desired by surplus units Repackage funds received from deposits to provide loans of the size and maturity desired by deficit units
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Bank Market Structure

Banks are continuing to consolidate:

Interstate

regulations were changed in 1994 to allow banks more freedom to acquire banks across state lines

Competition among banks increased Banks needed to become more efficient as a means of survival Acquisitions were a convenient method to grow quickly

The

number of banks today is about one-half that existed in 1985 The largest 100 banks now represent about 75 percent of all bank assets
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Bank Market Structure (contd)

Bank participation in financial conglomerates

Some commercial banks have acquired other types of financial service firms Conglomerates are composed to various units offering specialized services The Act gave banks and other financial service firms more freedom to merge, without having to divest some of the financial services that they acquired The Act allowed financial institutions to offer a diversified set of financial services

Impact of the Financial Services Modernization Act

Bank Market Structure (contd)

Benefits of diversified services to individuals and firms

Individuals and firms have various financial needs that they can now satisfy with one conglomerate Some financial conglomerates specialize in the services desired by individuals or large firms Financial institutions can reduce their reliance on the demand for any single service they offer Diversification may result in less risk for the institution The units of a financial conglomerate may generate some new business just because they offer convenience to clients who already rely on its other services

Benefits of diversified services to financial institutions

Bank Sources of Funds

A financial institutions liabilities represent its sources of funds Transaction deposits

A demand deposit account (checking account) is offered to customers who desire to write checks

A conventional account requires a small minimum balance and pays no interest

A negotiable order of withdrawal (NOW) account provides checking services as well as interest but requires a larger minimum balance Electronic transactions

About two-thirds of all employees in the U.S. have direct deposit accounts More than 60 percent of bank customers use ATMs Debit cards and preauthorized debits can be used for recurring monthly payments
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Bank Sources of Funds (contd)

Savings deposits
Until

1986, Regulation Q restricted the interest rate banks could offer on passbook savings
Ceilings prevented commercial banks from competing for funds during periods of higher interest rates

An

automatic transfer service (ATS) account allows customers to maintain an interest-bearing savings account that automatically transfers funds to their checking account when checks are written

Bank Sources of Funds (contd)

Time deposits
Time

deposits are deposits that cannot be withdrawn until a specified maturity date Retail certificates of deposit (CDs) require a specified minimum amount of funds to be deposited for a specified period of time

Annualized interest rates vary among banks and maturity types There is no organized secondary market Depositors will normally forgo a portion of their interest as a penalty for early withdrawal

Bank Sources of Funds (contd)

Time deposits (contd)

Certificates of deposit (contd)

Bull-market CDs reward depositors if the market performs well Bear-market CDs reward depositors if the market performs poorly Callable CDs can be called by the financial institution early

Pay a slightly higher interest rates, which compensates depositors for risk

Negotiable certificates of deposit (NCDs):

Are offered by some large banks to corporations Typically have short-term maturities Typically require a minimum deposit of $100,000 Do not have a secondary market

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Bank Sources of Funds (contd)

Money market deposit accounts (MMDAs):

Were

created with the Garn-St Germain Act of 1982 Differ from conventional time deposits in that they do not specify a maturity Are more liquid than retail CDs Normally pay a lower rate than retail CDs Differ from NOW accounts in that they provide limited check-writing ability

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Bank Sources of Funds (contd)

Federal funds purchased

Federal funds purchased represent a liability to the borrowing banks and an asset to the lending bank that sells them Loans in the federal funds market are typically for one to seven days The intent of federal funds transactions is to correct short-term fund imbalances experienced by banks The interest rate charged in the federal funds market is the federal funds rate

Typically between 0.25 percent and 1.00 percent above the T-bill rate

Banks that are short of required reserves on the average over a settlement period must compensate with additional reserves
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Bank Sources of Funds (contd)

Borrowing from the Federal Reserve banks

The

interest rate charged on loans from the Fed is the discount rate Loans from the discount window are commonly from one day to a few weeks The discount window is mainly used to resolve a temporary shortage of funds Banks commonly borrow in the federal funds market instead of the discount window because the Fed may disapprove of continuous borrowing by a bank
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Bank Sources of Funds (contd)

Repurchase agreements

A repurchase agreement (repo) represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price Banks use repos as a source of funds when they need funds just for a few days

The bank sells some government securities to a corporation and buys those securities back later

Repos occur through a telecommunications network connecting large banks, corporations, government securities dealers, and federal funds brokers Repo transactions are typically in blocks of $1 million The repo yield is slightly less than the federal funds rate
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Bank Sources of Funds (contd)

Eurodollar borrowing

Eurodollars are dollar-denominated deposits in banks outside the U.S. Eurobanks are foreign banks or foreign branches of U.S. banks that accept large short-term deposits and make short-term loans in dollars Banks issue bonds to finance fixed assets Common purchasers of bank bonds are households and various financial institutions Banks finance less with bonds than other corporations

Bonds issued by the bank

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Bank Sources of Funds (contd)

Bank capital
Bank

capital represents funds attained through the issuance of stock or through retained earnings
Represents the equity or net worth of the bank

Primary

capital results from issuing common or preferred stock or retained earnings Secondary capital results from issuing subordinated notes and bonds Banks generally avoid issuing new stock because:

It dilutes the ownership of the bank The banks reported EPS are reduced
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Bank Sources of Funds (contd)

Bank capital (contd)

A

higher level of capital is thought to enhance a banks safety because capital can absorb losses In 1981, regulators imposed a minimum primary capital requirement of 5.5 percent of total assets and a minimum total capital requirement of 6 percent of total assets In 1988, regulators imposed risk-based capital requirements that were completely phased in by 1992

The required level of capital is dependent on its risk Assets with low risk are assigned low weights, and assets with high risk are assigned high weights

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Bank Sources of Funds (contd)

Summary of Bank Sources of Funds
Savings deposits (incl. MMDAs)

8%
Transaction deposits

12%

30%
Borrowed funds Other sources

16% 10%

Small-denomination time deposits

24%

Large-denomination time deposits

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Uses of Funds by Banks

Cash
Banks

are required to hold some cash as reserves by reserve requirements imposed by the Fed Banks hold cash to maintain some liquidity and accommodate withdrawal requests Banks only hold as much cash as necessary because cash does not pay interest Banks hold cash in vaults and in their Fed district bank
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Uses of Funds by Banks (contd)

Bank loans
Loans

are the main use of bank funds Types of business loans

A working capital loan is designed to support ongoing business operations Term loans are used to finance the purchase of fixed assets

Conditions by which the borrower must abide are protective covenants Term loans are often amortized so that the borrower makes fixed payments If the loan principal is paid off in one balloon payment, it is a bullet loan

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Uses of Funds by Banks (contd)

Bank loans (contd)

Types of business loans (contd) A direct lease loan involves purchasing the assets and leasing them to the firm An informal line of credit allows the business to borrow up to a specified amount within a specified period of time A revolving credit loan obligates the bank to offer up to some specified maximum amount of funds over a specified period of time The interest rate charged by banks on loans to their

most creditworthy customers is known as the prime rate

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Uses of Funds by Banks (contd)

Bank loans (contd)

Loan

participations

Several banks pool their available funds in a loan participation One of the banks serves as the lead bank and other banks supply funds that are channeled to the borrower The lead bank receives fees for servicing the loan in addition to its share of interest payments All participating banks are exposed to credit risk
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Uses of Funds by Banks (contd)

Bank loans (contd)

Loans supporting leveraged buyouts

The loan amount provided by a single bank to support an LBO is usually between $15 million and $40 million LBO financing is attractive to banks because of the high loan rate Firms request LBO financing because they perceive that the market value of certain publicly held shares is too low Some banks originate the loans designed for LBOs and then sell them to other financial institutions Bank financing to corporate borrowers with a high degree of financial leverage (highly leveraged transactions) results in a debtto-asset ratio of at least 75 percent

About 60 percent of HLT funds are used to finance LBOs

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Uses of Funds by Banks (contd)

Bank loans (contd)

Collateral requirements on business loans Commercial banks are increasingly accepting intangible assets as collateral Lender liability on business loans Business that previously obtained loans are filing lawsuits claiming that the banks terminated further financing without sufficient notice

Prevalent in the farming industry

Volume of business loans Volume increased consistently throughout the 1990s and then declined in the 20012003 period

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Uses of Funds by Banks (contd)

Bank loans (contd)

Types

of consumer loans

Installment loans are used to finance purchases of cars and household products Banks provide credit cards to customers

State regulators can impose usury laws to restrict the maximum rate of interest charged by banks

The interest rate charged on credit card loans and personal loans is typically much higher than the cost of funds

Many banks have used more lenient guidelines when assessing the creditworthiness of potential customers

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Uses of Funds by Banks (contd)

Bank loans (contd)

Real

estate loans

For residential real estate, the maturity on a mortgage is typically 15 to 30 years

Loans are backed by the residence purchased

Banks provide some commercial real estate loans to finance commercial development

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Uses of Funds by Banks (contd)

Investments in securities

Banks purchase Treasury securities and government agency securities Government agency securities:

Can be sold in the secondary market Have a less active market than Treasury securities Are not a direct obligation of the federal government Are commonly issued by federal agencies such as Freddie Mac or Fannie Mae Generate interest income that is subject to state and local income taxes

Banks purchase investment-grade corporate and municipal securities

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Uses of Funds by Banks (contd)

Investments in securities (contd)

Bank investment in securities over Generally, banks hold securities that:

time

Offer a lower expected return than the loans they provide Offer more liquidity and are subject to lower default risk than loans they provide Firms are unwilling to expand Banks extend fewer loans and increase their purchases of securities

During weak economic conditions:

In the 1990s, banks used a relatively high proportion of their funds for loans In 2002, banks reduced their loans while increasing their investment in securities
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Uses of Funds by Banks (contd)

Federal funds sold

Funds lent out will be returned at a specified time with interest Small banks are common providers of funds in the federal funds market Banks can act as the lender on a repo by purchasing a corporations holdings of Treasury securities Eurodollar loans are provided by branches of U.S. banks located outside the U.S. and some foreign-owned banks Banks must maintain some amount of fixed assets so that they can conduct their business operations

Repurchase agreements

Eurodollar loans

Fixed assets

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Uses of Funds by Banks (contd)

Summary of Bank Uses of Funds
Loans to households

10% 22% 28%

Real estate loans Business loans Other loans

5% 14% 2% 5% 14%

Loans to foreign governments Cash and non-interest securities RA and fed funds Securities

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Uses of Funds by Banks (contd)

Impact of the September 11 Crisis

Households

shifted funds to short-term money market securities such as bank CDs to avoid risk Commercial banks:

Experienced substantial inflows of funds Had only limited use for funds because businesses were unwilling to expand Were especially cautious because they were already experiencing an increase in problems loans

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Off-Balance Sheet Activities

Off-balance sheet activities:

Generate fee income without requiring an investment of funds Create a contingent obligation for banks Are required to be recognized as assets or liabilities and reported at fair market value

A loan commitment is an obligation by a bank to provide a specified loan amount to a particular firm upon the firms request

e.g., a note issuance facility (NIF) requires banks to purchase the commercial paper of a firm if the firm cannot place its paper in the market at an acceptable interest rate

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Off-Balance Sheet Activities (contd)

A standby letter of credit (SLC) backs a customers obligation to a third party A forward contract is an agreement between a customer and a bank to exchange one currency for another on a particular future date at a specified exchange rate With a swap contract, two parties agree to periodically exchange interest payments on a specified notional amount of principal
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International Banking

Because of interstate banking barriers, U.S. commercial banks were better able to grow by penetrating foreign markets The most common way for banks to expand internationally is through branches
Must

obtain Fed approval based on financial condition and experience in international business Agencies located in foreign countries are allowed to provide loans, but not to accept deposits or provide trust services
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International Banking (contd)

Global competition in foreign countries

U.S.

banks have recently established foreign subsidiaries wherever they expect more foreign expansion by U.S. firms

e.g., Southeast Asia, Eastern Europe, and Latin America As a result of NAFTA, U.S. banks have expanded their business into Mexico to:

Help finance the establishment of subsidiaries by U.S.-based corporations Benefit from the increased international trade by offering bankers acceptances and foreign exchange services Offer credit card services and other households services in Mexico
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International Banking (contd)

Expansion by Non-U.S. banks in the United States

Initially,

non-U.S. banks entered primarily to serve non-U.S. corporations that set up subsidiaries in the U.S. Since 1913, Edge Act corporations have been established in the U.S. to specialize in international banking and foreign financial transactions

Can accept deposits and provide loans specifically related to international transactions

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International Banking (contd)

Impact of the euro on global competition

The

euro has increased bank expansion throughout Europe because the euro:
Simplifies transactions Reduces exposure to exchange rate risk Encourages firms to engage in a bond or stock offering to support their European business Makes it easier to achieve economies of scale and enables banks internal reporting systems to be more efficient

U.S.

banks and European banks are expanding throughout Europe by acquiring existing banks
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