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Chapter 9

Commercial Banking

©Thomson/South-Western 2006

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The Importance of Commercial Banks

Commercial banks dominate among depository institutions.

Banks take in funds by accepting checking, saving, and time deposits, and use the funds mainly to grant loans to homebuyers, businesses, and consumers.

Commercial banks are the oldest and most diversified of all financial intermediaries.

In 2005, commercial banks had some $8 trillion in total assets--more than 75 percent of the total assets of all depository institutions.

Banks are also important in the money supply process.

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The Commercial Bank Balance Sheet

Banks earn a profit on the “spread” (3%-4%) by obtaining funds at relatively low interest rates and lending at higher interest rates.

In recent years, fees have played an increasingly important role in bank profits.

A bank balance sheet is a statement of its assets, liabilities, and net worth at a given point in time. Assets are what it owns. Liabilities are what it owes. Net worth (capital accounts, capital) is the difference between its

assets and liabilities. Assets - Liabilities = Net Worth Assets = Liabilities + Net Worth

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Figure 9-1

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Table 9-1

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Commercial Bank Liabilities Transactions Deposits (checkable deposits)

Demand Deposits: non-interest bearing checking accounts Negotiable Order Of Withdrawal (NOW) Accounts: interest-bearing checking

accounts Automatic Transfer Service (ATS) Accounts:Paired accounts with checks on

non-interest baring accounts and automatic transfers to it from interest-bearing accounts

Non-Transactions Deposits

Passbook Savings Accounts Small Certificates of Deposit (CDs up to $100,000) Money Market Deposit Accounts (MMDAs) Negotiable CDs. Large CDs over $100,000

Non-deposit Borrowing

Borrowing from the Fed at the discount rate Borrowing from other banks at the federal funds rate

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Figure 9-2

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Commercial Bank Assets

Cash Assets: legal reserves as dictated by reserve requirements or required reserve ratios

Loans Real Estate Loans: collateralized by property, securitized or packaged

collections of loans Business Loans: regular installment loans, lines of credit Consumer Loans: auto loans, credit cards Other Loans: federal funds sold

Securities

Building, Land, and Equipment

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Figure 9-3

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Commercial Bank Capital Accounts

Bank capital derives from the issue of bank stock shares and from retained earnings.

In 2004, aggregate capital accounts of all U.S. commercial banks were 8.2 % of total bank assets.

Bank capital provides a cushion that protects

a bank's owners from potential bank insolvency.

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Writing Off Bad Loans

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Commercial Bank Management

Commercial banks strive to: earn solid profits; maintain extremely low exposure to the possibility

of becoming insolvent, and maintain high liquidity (the ability to immediately

meet currency withdrawals while abiding by existing reserve requirements) by managing liquidity and capital.

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T-Accounts T-accounts are statements of the change in the balance sheet

resulting from a given event. ie. if a customer withdraws $200 in cash from a savings account at the

Bank of Medicine Bow, Wyoming.

ie. Clearing a check for $12,000 written by a bank customer

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The Importance of Liquidity Banks must have emergency plans to meet

large reserve withdrawals, so banks need to hold liquid assets like Treasury bills.

If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account.

Banks that exhibit higher risk need larger capital accounts.

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The Liquidity-Risk Trade-off

With a reserve requirement of 10%, the bank has no excess reserves. Its assets are 90% in high return loans and 10% in low return securities. If depositors withdraw $20 million, then the balance sheet changes and the

bank must come up with $18 million, of which only $10 million is liquid.

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The Liquidity-Profitability Trade-off

The bank has $10 million excess reserves. Its assets are split between high return loans and low return

securities. If depositors withdraw $20 million, then the balance sheet

changes and the bank must come up with $8 million, but its assets are so liquid that this is no problem.

It is less profitable because it has fewer high-risk, high-return loans on equity for bank owners.

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Indicators of Bank Liquidity

The ratio of bank loans to total assets 35% in 1950s vs 60% in 2004

The ratio of securities to total assets 40% in 1950s vs 15% today

The ratio of demand deposit to total bank deposits 60% in 1960 vs 10% today

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Liability Management Banks look for good lending opportunities and then search for

the funds to finance these loans. When a large bank finds a profitable lending opportunity, it

can: “buy” federal funds; issue negotiable CDs at whatever interest rate is required to attract

funds; issue repurchase agreements or borrow Eurodollars, or obtain funds through the commercial paper market.

Aggressive liability management allows banks to make profitable loans that they would otherwise have to turn down.

Aggressive liability management can be dangerous, because a bank’s assets typically have longer maturities than its liabilities. If interest rates rise sharply, banks can suffer severe losses.

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Capital Management

Bank capital provides a financial cushion so that transitory adverse developments will not cause insolvency.

Bank capital also protects bank managers and owners from

their own mistakes and from various risks: default risk, interest-rate risk, liquidity risk, political or country risk, and management risk.

Given other factors, a higher bank capital ratio (capital/assets) implies a lower risk of insolvency, but also a lower rate of return.

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The Capital Management Tradeoff

Earnings/Capital = Earnings/Total assets x Total assets/Capital

The left-hand side of the expression is the rate of return on equity, or rate of return on capital

The first expression on the right-hand side is the rate of return on total assets.

The final expression is the equity multiplier: the amount of leverage that is applied to the rate of return on total assets. A high capital/assets ratio represents a low equity multiplier; a low capital/assets ratio implies a high equity multiplier.

A trade-off arises between short-run profitability and the risk of insolvency.

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Figure 9-4