Commercial Bank Operations Chapter 17 Commercial Bank Operations Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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

Commercial Banks as Financial Intermediaries Commercial banks serve all types of surplus and deficit units Offer 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

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

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

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

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

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

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

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

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

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

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

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

Bank Sources of Funds (cont’d)

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

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

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

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

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

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

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

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

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

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

Uses of Funds by Banks (cont’d)

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

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

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

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