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Chapter 17

Commercial Bank Operations

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

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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

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Commercial Banks as Financial Intermediaries Commercial banks serve all types of

surplus and deficit unitsOffer 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 (cont’d)

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 Impact of the Financial Services Modernization Act

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

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Bank Market Structure (cont’d)

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 Benefits of diversified services to financial institutions

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

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Bank Sources of Funds A financial institution’s 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 (cont’d)

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

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Bank Sources of Funds (cont’d)

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

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Bank Sources of Funds (cont’d)

Time deposits (cont’d) Certificates of deposit (cont’d)

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 (cont’d)

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 (cont’d)

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 (cont’d)

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 (cont’d)

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 (cont’d)

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

Bonds issued by the bank 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

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Bank Sources of Funds (cont’d)

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 bank’s reported EPS are reduced

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Bank Sources of Funds (cont’d) Bank capital (cont’d)

A higher level of capital is thought to enhance a bank’s 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 (cont’d)

Summary of Bank Sources of Funds

30%

24%10%

16%

12%

8%

Savings deposits (incl.MMDAs)

Transaction deposits

Borrowed funds

Other sources

Small-denomination timedeposits

Large-denomination timedeposits

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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 (cont’d)

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 (cont’d)

Bank loans (cont’d) Types of business loans (cont’d)

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 (cont’d)

Bank loans (cont’d)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 (cont’d)

Bank loans (cont’d) 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 debt-to-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 (cont’d)

Bank loans (cont’d) 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 2001–2003 period

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Uses of Funds by Banks (cont’d)

Bank loans (cont’d) 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 (cont’d)

Bank loans (cont’d)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 (cont’d)

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 (cont’d)

Investments in securities (cont’d) Bank investment in securities over time

Generally, banks hold securities that: Offer a lower expected return than the loans they provide Offer more liquidity and are subject to lower default risk than

loans they provide During weak economic conditions:

Firms are unwilling to expand Banks extend fewer loans and increase their purchases of

securities 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 (cont’d) 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 Repurchase agreements

Banks can act as the lender on a repo by purchasing a corporation’s holdings of Treasury securities

Eurodollar loans Eurodollar loans are provided by branches of U.S. banks located

outside the U.S. and some foreign-owned banks Fixed assets

Banks must maintain some amount of fixed assets so that they can conduct their business operations

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Uses of Funds by Banks (cont’d)

Summary of Bank Uses of Funds

10%

28%

14%5%2%

14%

5%

22%

Loans to households

Real estate loans

Business loans

Other loans

Loans to foreigngovernments

Cash and non-interestsecurities

RA and fed funds

Securities

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Uses of Funds by Banks (cont’d)

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 firm’s 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 (cont’d)

A standby letter of credit (SLC) backs a customer’s 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 (cont’d) 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

banker’s acceptances and foreign exchange services Offer credit card services and other households services in

Mexico

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International Banking (cont’d) 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 (cont’d) 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