Commercial Bank Behavior

1
Commercial Bank Behavior

• Is Banking Becoming More Competitive?

2
Recent Bank Mergers

• 1990 ABN and AMRO (218 billion)
• 1996 Chemical Bank and Chase Manhattan (297
  billion)
• 1996 Mitsubishi Bank and Bank of Tokyo (752
  billion)
• 1997 Union Bank of Switzerland and Swiss Bank
  (595 billion)
• 1997 NationsBank and Barnett (310 billion)
• 1998 Royal Bank and Bank of Montreal (330
  billion)
• 1998 Toronto Dominion and CIBC (320 billion)
• 1998 NationsBank and BankAmerica (570 billion)
• 1998 Banc One and First Chicago NBD (240
  billion)
• 1998 Citicorp and Travelers (700 billion)
• 2003 Bank of America and Fleet (851billion)
• 2003 JP Morgan and Bank One (1trillion)

The last 20 years has seen considerable
consolidation in the banking industry
3
Consolidation has created a market where a small
group of large banks controls a majority of total
assets
Assets Number of Banks Share of Banks () Share of Assets ()
gt25M 1211 14 .4
25-50M 1851 21.5 1.2
50-100M 2179 25.3 2.8
100-500M 2693 31.2 9.8
500M-1B 296 3.4 3.7
1-10B 314 3.6 15.9
lt10B 77 .9 66.1
Total 8621 100 100
4
The 10 largest banks in the US control around 40
of all banking assets
Bank Assets (Billions)
Citigroup 1,497
JP Morgan Bank One 1,097
Bank of America Fleet 851
Wells Fargo 349
Wachovia 341
Met Life 277
Washington Mutual 268
US Bancorp 180
ABN Amro N America 140
Bank Boston 75
Total 5,075
5
Concentration Ratios
The concentration ratio is the percentage of
market share owned by the largest m firms in the
industry (usually 4, 8, 20, 50)
6
Concentration Ratios
7
However while the US is the worlds largest
economy, only three of the ten largest banks in
the world are American.
Bank Assets (Billions)
Citigroup (US) 1,497
JP Morgan Bank One (US) 1,097
Mizuho Financial Group (Japan) 1,080
Bank of America First Union (US) 851
UBS (Switzerland) 851
Sumitomo Mitsui (Japan) 844
DeutscheBank (Germany) 795
Mitsubishi Tokyo (Japan) 781
HSBC (UK) 759
BNP Paribas (France) 744
8
The bankers optimization problem has three
dimensions
As a financial intermediary, a bank must solve
the informational problems that exist between
borrowers and lenders (moral hazard and adverse
selection)
As a portfolio manager, a bank must choose a
portfolio composition to minimize risk
As a competitive firm, the bank must choose
prices (interest rates) to maximize profits)
9
As a financial intermediary, a bank must solve
the informational problems that exist between
borrowers and lenders (moral hazard and adverse
selection)
Most of the informational problems that exist
between the bank and potential depositors have
been solved through regulation and insurance
(FDIC), but the bank must still deal with the
moral hazard and adverse selection problems
associated with its loan customers

• Diversification
• Loan Covenants
• Credit Rationing (Credit Limits)
• Credit Scoring

10
Credit scoring is an attempt to estimate loan
default rates based on observable
characteristics. The most common credit score was
developed by Fair/Isaac Co. and is known as your
FICO number (300 850)
These are NOT in a FICO Score
Key Components of FICO Score

• How you pay your bills (35)
• Amount of Debt/Amount of Available Credit (30)
• Length of Credit History (15)
• Mix of Credit (Types of Loans) (10)
• Applications for new credit (10)

• Age
• Race
• Employment
• Income
• Education
• Marital Status

To estimate your FICO score, click here
11
Credit Score of Population Interest Rate
499 and below 1 ------
500 - 549 5 9.29
550 - 599 7 8.53
600 - 649 11 7.71
650 - 699 16 6.56
700 - 749 20 6.02
750 - 799 29 5.90
800 - 850 11 5.90
Interest Rate on a 150,000 , 30 Year Fixed
Rate Mortgage
12
As a competitive firm, the bank must choose
prices (interest rates) to maximize profits)
A bank makes its profits from the spread between
the interest rate it charges on loans and the
interest rate it pays on deposits
(Interest rate on loans) (Quantity of loans)

(Quantity of Deposits) (Interest paid on
deposits)
Profits
Note This is ignoring income from fees!
13
Acme National Bank
Assets
Liabilities
5,000 (Cash) - 0
100,000 (Checking) - 0
Profits equal revenues minus costs
100,000 (Savings) - 2
10,000 (Reserves) - 0
50,000 (T-Bills) - 4
100,000 (1 yr. CD) - 3
100,000(5 yr. Loans) 5
65,000 (5 yr. CD) 4
300,000 (30 yr Mort.) 7
Assets Liabilities 100,000 (Equity)
Profit .04 (50,000) .05 (100,000)
.07(300,000) 28,000
- .02(100,000) .03(100,000) .04 (65,000)
7,600
20,400
However, profits dont take into account the
scale of operations (How large is the bank?)
14
Acme National Bank
Assets
Liabilities
5,000 (Cash) - 0
100,000 (Checking) - 0
100,000 (Savings) - 2
10,000 (Reserves) - 0
Profit
20,400
50,000 (T-Bills) - 4
100,000 (1 yr. CD) - 3
100,000(5 yr. Loans) 5
65,000 (5 yr. CD) 4
300,000 (30 yr Mort.) 7
Assets Liabilities 100,000 (Equity)
Total Assets 465,000
After Tax Profits
20,400
Return on Assets (ROA)


.044 (4.4)
Total Assets
465,000
After Tax Profits
20,400
Return on Equity (ROE)


.20 (20)
Equity
100,000
15
ROE vs. ROA

• Company A
• Assets 100
• Profits 10
• Debt 20
• Equity 80_________
• ROA 10
• ROE 12.5

• Company B
• Assets 100
• Profits 10
• Debt 80
• Equity 20_________
• ROA 10
• ROE 50

The more leveraged a firm is, the higher the
return to equity for a given ROA. However, a
highly leveraged firm carries more risk!
16
Equity Capital to Assets in Banking
17
Return on Assets
18
Return on Equity
19
Acme National Bank
Assets
Liabilities
5,000 (Cash)
100,000 (Checking)
100,000 (Savings)
10,000 (Reserves)
50,000 (T-Bills)
100,000 (1 yr. CD)
100,000(5 yr. Loans)
65,000 (5 yr. CD)
300,000 (30 yr Mort.)
Assets Liabilities 100,000 (Equity)
Total Assets 465,000
A Bank also faces two constraints
Federal Reserve
Cash Reserves (Reserve Requirement)
(Checkable Deposits)
(.05)(100,000) 5,000
Basel Accord
Equity (.04)(Assets) (.04)(465,000) 18,600
20
Lets assume that you have the only bank in town.
You offer one type of loan a 30 year 100,000
fixed APR mortgage. You offer savings accounts
that pay 3 interest per year.
21
You have monthly fixed costs equal to 20,000.
Further, you have annual administrative costs
equal to 1 of your total funds raised.
Let Q Total Number of Loans
.03
.01
20,000
Total Monthly Costs
100,000
Q
100,000
Q
12
12
Fixed Cost
Interest Cost
Administrative Costs
For example, if you want to create 3 mortgages,
you will need to raise 300,000 in deposits that
will earn 9,000 per year (3 of 300,000) and
incur 3,000 (1 of 300,000) in administrative
expenses. Total Monthly Cost 20,000 750
250 21,000
22
Let Q Total Number of Loans
.04
20,000
Total Monthly Costs
100,000
Q

12
Fixed Costs
Variable Costs
Cost
Slope 333.33
21,000
20,000
of Loans
3
23
You have estimated the demand for mortgages to be
as follows
Q 95.0 - 624 ( r ) 90.4 ( UR )
Unemployment Rate
Interest Rate Charged
For example, if you set your mortgage rate at 6
(.06) and the local unemployment rate is 5
(.05), you will be able to sell 53 mortgages
Q 95.0 - 624 (.06) 90.4 (.05) 53.04
Your total revenues would be 100,000 (53)(.06)
318,000
24
Q 95.0 - 624 ( r ) 90.4 ( UR )
(Demand)
OR
Interest Rate
95.0
1
90.4
-
-
r
Q
UR
(Inverse Demand)
624
624
624
6
UR 5
of Loans
53.04
95.0
1
90.4
-
-
r
(53.04)
(.05)
.06
624
624
624
25
Q 95.0 - 624 ( r ) 90.4 ( UR )
Interest Rate
6
UR 5
of Loans
53.04
Elasticity of Demand refers to the responsiveness
of demand to price changes (here, the price is
the interest rate)
26
Revenue Maximization.
2
Total Revenues Q(100,000)r
100,000
95.0 r
- 642 r
- 90.4 (UR) r
Q 95.0 - 624 ( r ) 90.4 ( UR )
Maximizing Total Revenues involves taking the
derivative with respect to the interest rate and
setting it equal to zero
95.0
- 2 (624) r
- 90.4 (UR)
0
Solving for r
95 90.4(UR)
r
2 (624)
27
If the unemployment rate is equal to 5, the
revenue maximizing loan rate is 7.25
95 90.4(.05)
.0725
r
2 (624)
Revenues 100,000 (45.24)(.0725) 327,825
7.25
Total Revenues
UR 5
of Loans
45.24
95.0 - 624 ( .0725 ) 90.4 (.05 )
28
Profit Maximization
Total Revenues Q (100,000) r
95.0
1
90.4
-
-
r
Q
UR
624
624
624
2
Total Revenues
1
90.4
95.0
-
-
Q
UR
100,000
100,000
100,000
Q
Q

624
624
624
2
Total Revenues
-

15,224 - 14,487 UR
Q
Q
160
29
Profit Maximization
2
Total Revenues
-

15,224 - 14,487 UR
Q
Q
160
Marginal Revenue is the derivative of Total
Revenue with respect to Q

Marginal Revenues
-

15,224 - 14,487 UR
Q
320
100,000Demand
MR
Quantity
30
Profit Maximization
.04
20,000
Total Monthly Costs
100,000
Q

12
Marginal Cost is the derivative of Total Cost
with respect to Q

Total Costs
Marginal Costs
333.33

Quantity
31
Profit Maximization
Profits Total Revenues Total Costs
Maximization Condition
Marginal Revenues Marginal Costs
-
333.33
15,224 - 14,487 UR
Q
320

UR .05
Q

44
Solving for Q
95.0
1
90.4
-
-
r
Q
UR
.0745 (7.45)
624
624
624
32
Profits Total Revenues Total Costs
Revenues 100,000 (44)(.0745)
327,800
.04
20,000
Total Monthly Costs
100,000
44

34,666

-
12
293,134
Profits
7.45
MC
100,000Demand
MR
Quantity
44
33
Over time, more banks move into the area..
34
Elasticity of Demand refers to the responsiveness
of demand to price changes as number of banks
increases, demand becomes more elastic
Interest Rate
More elastic
Less elastic
Q
This number gets bigger!
Q 95.0 - 624 ( r ) 90.4 ( UR )
35

• As Demand Becomes more elastic
• The Spread between price (interest rate) and
  costs decreases
• Quantity increases
• Profits decrease

Interest Rate
r
MC
Demand
MR
Q
Q
This number gets bigger!
Q 95.0 - 624 ( r ) 90.4 ( UR )
36
As long as there are profits to be made, more
banks enter the area. Eventually, price
marginal costs and profits drop to zero.
37
Banking Spreads
38
Banking Spreads
39
As a portfolio manager, a bank must choose a
portfolio composition to minimize risk
Acme National Bank
Assets
Liabilities
5,000 (Cash)
100,000 (Checking)
100,000 (Savings)
10,000 (Reserves)
50,000 (T-Bills)
100,000 (1 yr. CD)
100,000(5 yr. Loans)
65,000 (5 yr. CD)
300,000 (30 yr Mort.)
Assets Liabilities 100,000 (Equity)
21.5 of Assets
Suppose that the yield curve shifts up by 100
basis points
40
Acme National Bank
Durations are indicated in parentheses
Assets
Liabilities
5,000 (Cash) (0)
100,000 (Checking) (0)
100,000 (Savings) (0)
10,000 (Reserves) (0)
50,000 (T-Bills) (1)
100,000 (1 yr. CD) (1)
100,000(5 yr. Loans) (3)
65,000 (5 yr. CD) (5)
300,000 (30 yr Mort.) (15)
Assets Liabilities 100,000 (Equity)
21.5 of Assets
50,000
100,000
300,000
Duration (Assets)
1
3
15 10.4
465,000
465,000
465,000
100,000
65,000
Duration (Liabilities)
1
5 1.16
365,000
365,000
41
Acme National Bank
Assets
Liabilities
5,000 (Cash) (0)
100,000 (Checking) (0)
100,000 (Savings) (0)
10,000 (Reserves) (0)
50,000 (T-Bills) (1)
100,000 (1 yr. CD) (1)
100,000(5 yr. Loans) (3)
65,000 (5 yr. CD) (5)
300,000 (30 yr Mort.) (15)
Assets Liabilities 100,000 (Equity)
21.5 of Assets
Liabilities
Duration Gap Duration (Assets) Duration
(Liabilities)
Assets
365,000
10.4 1.16
9.5
465,000
42
Acme National Bank
Assets
Liabilities
5,000 (Cash) (0)
100,000 (Checking) (0)
100,000 (Savings) (0)
10,000 (Reserves) (0)
50,000 (T-Bills) (1)
100,000 (1 yr. CD) (1)
100,000(5 yr. Loans) (3)
65,000 (5 yr. CD) (5)
300,000 (30 yr Mort.) (15)
Assets Liabilities 100,000 (Equity)
Duration Gap 9.5
21.5 of Assets
For every 100 basis point increase in the yield
curve, this banks equity (as a percentage of
assets) drops by 9.5
How much of an interest rate change can this bank
withstand before it inadequately capitalized?