CHAPTER 16

COMMERCIAL BANK OPERATIONS

The Development of Modern Banking

• In the middle ages, metalsmiths performed a safekeeping function and issued depository receipts as proof of ownership.

• Eventually, standardized receipts were used as a medium of exchange.

• Goldsmiths began to loan out some of the gold coins they were holding, keeping only a fraction of the coins that were on deposit. This was the beginning of fractional reserve banking.

The Development of Modern Banking (concluded)

• Goldsmiths began to loan standardized receipts rather than gold coins. These goldsmiths eventually became known as banks and their standardized receipts became known as banknotes.

• The last step necessary for the development of modern banking was the evolution of demand deposits -- the ability to write an order to the bank to transfer banknotes.

An Overview of the Banking Industry Today

• The commercial banking industry is comprised of less than 9,000 banks. The number of banks has declined from a peak of 15,000 in 1980.

• Commercial banks' geographic expansion has been constrained by state and federal banking legislation, but these constraints have been almost eliminated.

• Consequently, while the number of banks has declined, the total number of bank branches has grown to about 70,000.

An Overview of the Banking Industry Today (continued)

After the 1950s the number of banks and branches increased until the late 1980s. With the beginning of interstate banking and the emergence of electronic banking, the number of banks began declining. The number of branches per bank, however, continues increasing.

Source: FDIC Statistics on Banking.

NUMBER OF BANKS AND BRANCHES OF COMMERCIAL BANKS

(1920-1998)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

1920 1929 1935 1945 1955 1965 1975 1985 1990 1995 1996 1998

Year

Nu

mb

er

of

Off

ice

s

Number of BranchesNumber of Banks

An Overview of the Banking Industry Today (concluded)

• The decline in the number of banks can be attributed to the rapid pace of consolidation in the industry.

• Large banks dominate asset and deposit holdings in the industry.

Bank Licensure

• Charters– Bank Licenses from two sources

• Federal Charters – National Banks

– OCC

• State Charters – State Banks

– State Banking Authorities

Bank Sources of Funds -- Liabilities and Capital

• Demand deposits accounts (DDA) represent funds transferable on the presentation of a check written by a customer.

• Savings Accounts -- Traditional nontransaction bank deposits.

• Certificates of Deposit -- Deposit contracts issued with varied names for a specific period of time. The largest category of bank deposits.

• Borrowed Funds -- Nondeposit, uninsured sources of funds. (from other banks)

Bank Sources of Funds -- Liabilities and Capital (continued)

• Capital Notes and Bonds -- Nondeposit, noninsured, subordinated long-term notes and bonds.

• Bank Capital Accounts– a source of funds.

– an equity base for deposits.

– a residual, at risk source of funds from shareholders that is used to absorb losses and protect depositors.

Bank Sources of Funds -- Liabilities and Capital (concluded)

0

1,000

2,000

3,000

4,000

5,000

6,000

1935

1945

1955

1965

1975

1985

1990

1995

1996

1997

1998

Year

Do

llars

in B

illio

ns

Total Capital

Other Liabilities

Subordinated Notes andDeb.

Borrowed Funds

Deposits

Source: FDIC Statistics on Banking.

Assets of Commercial Banks (1998)

All Insured CommercialBanksa

SmallBanksb

Medium-Sized Banksc

LargeBanksd

Assset Accounts Billions Percente Percente Percente Percente

Cash and Due from DepositoryInstitutions

$307 6 5 4 6

Securities, Total 923 18 26 26 15U.S. Treasury 125 2 5 4 2U.S. Government Agency 555 11 15 16 9State and Local Government 84 2 5 5 1Other 159 3 1 1 3

Federal funds Sold and SecuritiesPurchased Under RepurchaseAgreements

288 5 6 4 6

Loans and Lease Financing, Total 3,089 59 59 61 58Commercial and Industrial 874 17 10 11 18Depository Institutions 101 2 0 0 2Real Estate 1,300 25 33 38 22

Residential 879 17 18 21 16Commercial 358 7 9 13 6Other Real Estate 63 1 6 4 0

Agriculture 48 1 7 2 0Consumer 555 11 9 9 11

Credit Cards 216 4 0 1 5Other Consumer 339 6 8 8 6

Lease Financing Receivables 117 2 0 0 3Other 94 2 0 1 2

Trading Account Assets 306 6 0 0 7Bank Premises and Fixed Assets 70 1 2 2 1Intangible Assets 77 1 0 0 2Other Assets 209 4 2 2 4

Total Assets $5,269 100 100 100 100

Source: FDIC, Statistics on Banking, September 30, 1998.

Uses of Funds -- Bank Assets

• Cash assets• Federal Funds sold represent excess reserves sold

to other banks for a short period of time.• Bank investments provide income and liquidity.

– U.S. Treasury securities offer safety, liquidity, collateral, and income.

– U.S. government agency securities provide safety and income.

– Municipal securities provide income and a tax shield.

Bank loans

• Loans are generally more risky than the investment portfolio.

• Bank loans consist of promissory notes -- a financial asset similar to securities.

• Banks make fixed rate or floating rate loans.

• Many loans are secured by collateral; others are unsecured.

Commercial and industrial loans represent the major loan category of banks.

• Bridge loans -- a business financing agreement with repayment coming from the completion of the agreement.

• Seasonal loans -- financing of varying working capital needs over a year with repayment coming from the reduction in working capital.

• Long-term asset loans -- financing equipment over several years with repayment coming from future profits and cash flows of the borrower.

Other Loans

• Loans to depository institutions -- loans to respondent banks, S&Ls, and foreign banks.

• Real estate loans -- fixed or variable rate long-term loans– residential mortgage loans– commercial and industrial loans

Other Loans (concluded)

• Consumer loans to individuals– most are paid back in installments

– includes credit card and purchase credit

• Bank Credit Cards -- credit extended to consumer at the time of purchase and/or cash advance:– once local, credit card networks are now worldwide

– bank earns fees from annual fee, merchant discount and interest on revolving credit balances

The prime rate is the commercial loan rate posted by banks.

• Traditionally, most loans were tied to the prime rate, but today other market rates such as LIBOR, Treasury or CD rates are used as loan pricing reference rates.

• The prime rate remains a popular media indicator of changing credit conditions.

• The prime rate lags or follows market rates.

Base Rate Loan Pricing

• Most banks use a base rate of interest as a markup base for loan rates.

• The base rate may be the prime rate, the Federal Funds rate, LIBOR, or the Treasury rate and is expected to cover the following:– the cost of funds of the bank.

– the bank's administrative costs

– a fair return to the bank shareholders

Base Rate Loan Pricing Factors

• an upward adjustment from prime for default risk.

• an adjustment for term to maturity.

• an adjustment for competitive factors.

Match-funding Loan Pricing

• The loan rate is determined by adding a spread to the deposit cost to cover administrative costs, default risk, and a competitive return to bank shareholders.

• By matching the maturities of sources and uses, changing market interest rates are less likely to affect bank earnings.

Analysis of Loan Credit Risk: The 5 C’s of Credit

• character -- willingness to pay.

• capacity -- cash flow.

• capital -- wealth.

• collateral -- pledged assets.

• conditions -- current economic conditions.

Fee-Based Services

• Fee-based services have become important sources of bank revenue.

• Correspondent banking involves the sale of bank services to other banks and institutions.

• Bank leasing is an important type of credit service. (Nationsrent)

• Trust operations involve the bank acting in a fiduciary capacity for customers.

Fee-Based Services (continued)

• Investment products such as brokerage services and mutual funds are relatively new, but increasingly important sources of fee income.

• Banks are allowed to market certain types of Insurance products, such as annuities.

Off-balance Sheet Banking

• Off-balance-sheet activities are fee-based activities that give rise to contingent assets and liabilities.

Off-balance Sheet Banking (continued)

• Loan commitments enable lender and borrower to plan future cash flows.– A line of credit is an informal agreement between

the bank and customer to lend up to a maximum amount.

– A term loan is an amortized payment loan agreement for a period usually exceeding a year.

– A revolving credit is a formal agreement to lend a maximum amount for a period of time, usually greater than one year.

Off-balance Sheet Banking (continued)

• Letters of credit– A commercial letter of credit involves a bank

guaranteeing payment for goods in a commercial transaction.

– A standby letter of credit (SLC) is a contingent liability whereby the bank guarantees the terms and contract of a customer.

Off-balance Sheet Banking (continued)

• Loan brokerage involves the origination and sale of loans. The bank earns a fee for origination and servicing. The lending is provided by other direct or indirect investors.

• Derivative securities such as interest rate and currency forwards, futures, options, and swaps are an increasingly important part of bank’s off-balance-sheet commitments.

Off-balance Sheet Activities (1998)

All Insured CommercialBanksa

SmallBanksb

Medium-Sized Banksc

LargeBanksd

Off-Balance-Sheet Items Billions Percent ofAssetse

Percente Percent ofAssetse

Percent ofAssetse

Unused Commitments, Total 3,617 69 34 45 75Credit Card Lines 2,019 38 27 33 40Other Unused Commitments 1,598 30 7 12 35

Letters of Credit, Total 273 5 0 1 6Commercial 30 1 0 0 1Financial Standby 199 4 0 0 5Performance Standby 44 1 0 0 1

Assets Transferred With Recourse 306 6 0 0 7Derivative Contracts 33,449 635 0 1 781

Credit Derivatives 162 3 0 0 4Interest Rate Contracts 23,839 452 0 1 557

Notional Value of Swaps 11,680 222 0 1 273Futures and Forward Contracts 5,938 113 0 0 139Written Option Contracts 3,085 59 0 0 72Purchased Option Contracts 3,137 60 0 0 73

Foreign Exchange Contracts 8,763 166 0 0 205Notional Value of Swaps 624 12 0 0 15Futures and Forward Contracts 6,402 122 0 0 150Written Option Contracts 878 17 0 1 21Purchased Option Contracts 859 16 0 1 20

Other Commodity Contracts 685 13 0 0 16

Source: FDIC, Statistics on Banking, September 30, 1998.

Securitization

• Mortgage, auto or credit card loans are pooled together in a trust arrangement.

• Securities, called certificates, are sold to individual and institutional investors.

• The cash flow collections from the loans are forwarded to the trust and investors.

Securitization (concluded)

• The bank earns loan origination fees, perhaps underwriting fees, and loan servicing fees, and the funds raised by the securitization are used to originate more loans.

• Securitizing loans enables the bank to generate fees without added bank equity capital, required reserves (no funding needed), and deposit insurance premiums.

The Structure of a TypicalAsset Securitization

Bank Holding Companies

• The bank holding company is the major form of organization for banks in the United States and was used:– To achieve geographic expansion.

– To offer traditional nonbanking financial services.

– To reduce their tax burden.

• The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act allowed banks to acquire banks in other states.

Bank Holding Companies (concluded)

• Bank Holding Companies were first regulated under the Bank Holding Company Act of 1956, with major amendments made in 1970 to include one-bank holding companies under the definition of a bank holding company.– There was a concern about concentrated economic

power and concern that troubled bank holding companies could undermine the confidence in commercial banks.

– The Federal Reserve regulates bank holding companies.