COMMERCIAL BANK OPERATIONS

1
CHAPTER 16

• COMMERCIAL BANK OPERATIONS

2
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.

3
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.

4
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.

5
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.
6
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.

7
Bank Licensure

• Charters
• Bank Licenses from two sources
• Federal Charters National Banks
• OCC
• State Charters State Banks
• State Banking Authorities

8
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)

9
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.

10
Bank Sources of Funds -- Liabilities and Capital
(concluded)
Source FDIC Statistics on Banking.
11
Assets of Commercial Banks (1998)
Source FDIC, Statistics on Banking, September
30, 1998.
12
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.

13
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.

14
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.

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Other Loans

• Loans to depository institutions -- loans to
  respondent banks, SLs, and foreign banks.
• Real estate loans -- fixed or variable rate
  long-term loans
• residential mortgage loans
• commercial and industrial loans

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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

17
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.

18
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

19
Base Rate Loan Pricing Factors

• an upward adjustment from prime for default risk.
• an adjustment for term to maturity.
• an adjustment for competitive factors.

20
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.

21
Analysis of Loan Credit Risk The 5 Cs of Credit

• character -- willingness to pay.
• capacity -- cash flow.
• capital -- wealth.
• collateral -- pledged assets.
• conditions -- current economic conditions.

22
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.

23
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.

24
Off-balance Sheet Banking

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

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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.

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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.

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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 banks
  off-balance-sheet commitments.

28
Off-balance Sheet Activities (1998)
Source FDIC, Statistics on Banking, September
30, 1998.
29
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.

30
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.

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The Structure of a TypicalAsset Securitization
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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.

33
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.