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)
NUM BER OF BA NKS AND BR ANC HES OF
COM M E RC IAL BA NKS
(1920-1998)
80,000
Number of Offices
70,000
60,000
50,000
Number of Branches
Number of Banks
40,000
30,000
20,000
10,000
0
1920
1929
1935
1945
1955
1965
1975
1985
1990
1995
1996
1998
Year
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.
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)
6,000
5,000
Dollars in Billions
T otal C ap ital
4,000
O th er L iab ilities
3,000
S u b ord in ated N otes an d
D eb .
B orrow ed F u n d s
2,000
D ep osits
1,000
Year
Source: FDIC Statistics on Banking.
98
19
97
19
96
19
95
19
90
19
85
19
75
19
65
19
55
19
45
19
19
35
0
Assets of Commercial Banks
(1998)
Assset Accounts
Cash and Due from Depository
Institutions
Securities, Total
U.S. Treasury
U.S. Government Agency
State and Local Government
Other
Federal funds Sold and Securities
Purchased Under Repurchase
Agreements
Loans and Lease Financing, Total
Commercial and Industrial
Depository Institutions
Real Estate
Residential
Commercial
Other Real Estate
Agriculture
Consumer
Credit Cards
Other Consumer
Lease Financing Receivables
Other
Trading Account Assets
Bank Premises and Fixed Assets
Intangible Assets
Other Assets
Total Assets
All Insured Commercial
Banksa
Billions
Percente
$307
6
Small
MediumBanksb Sized Banksc
Percente
Percente
5
4
Large
Banksd
Percente
6
923
125
555
84
159
288
18
2
11
2
3
5
26
5
15
5
1
6
26
4
16
5
1
4
15
2
9
1
3
6
3,089
874
101
1,300
879
358
63
48
555
216
339
117
94
306
70
77
209
59
17
2
25
17
7
1
1
11
4
6
2
2
6
1
1
4
59
10
0
33
18
9
6
7
9
0
8
0
0
0
2
0
2
61
11
0
38
21
13
4
2
9
1
8
0
1
0
2
0
2
58
18
2
22
16
6
0
0
11
5
6
3
2
7
1
2
4
$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)
Off-Balance-Sheet Items
Unused Commitments, Total
Credit Card Lines
Other Unused Commitments
Letters of Credit, Total
Commercial
Financial Standby
Performance Standby
Assets Transferred With Recourse
Derivative Contracts
Credit Derivatives
Interest Rate Contracts
Notional Value of Swaps
Futures and Forward Contracts
Written Option Contracts
Purchased Option Contracts
Foreign Exchange Contracts
Notional Value of Swaps
Futures and Forward Contracts
Written Option Contracts
Purchased Option Contracts
Other Commodity Contracts
All Insured Commercial
Banksa
Billions
Percent of
Assetse
3,617
69
2,019
38
1,598
30
273
5
30
1
199
4
44
1
306
6
33,449
635
162
3
23,839
452
11,680
222
5,938
113
3,085
59
3,137
60
8,763
166
624
12
6,402
122
878
17
859
16
685
13
Source: FDIC, Statistics on Banking, September 30, 1998.
Small
MediumBanksb Sized Banksc
Percente
Percent of
Assetse
34
45
27
33
7
12
0
1
0
0
0
0
0
0
0
0
0
1
0
0
0
1
0
1
0
0
0
0
0
0
0
0
0
0
0
0
0
1
0
1
0
0
Large
Banksd
Percent of
Assetse
75
40
35
6
1
5
1
7
781
4
557
273
139
72
73
205
15
150
21
20
16
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 Typical
Asset 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.