The Commercial Banking Industry: Structure, Products, & Management Chapter 14 The Commercial Banking Industry: Structure, Products, & Management

 Learning Objectives  To understand how important commercial banks are to the functioning of a modern economy and financial system. To explore the structure of the United States’ banking industry. To learn about bank financial statements and how to read them. To see how banks create and destroy money and credit, and why this activity is vital.

Introduction The dominant privately owned financial institution in the U.S. and in the economies of most major countries is the commercial bank. This institution offers the public both deposit and credit services, as well as a growing list of newer and more innovative services, such as investment advice, security underwriting, selling insurance, and financial planning.

The Structure of U.S. Commercial Banking Number of Operating Commercial Banks in the U.S. at Year-end 2003 Source: Federal Deposit Insurance Corporation

A Trend Toward Consolidation One of the most important structural changes affecting the banking industry in recent years is the drive toward consolidation of industry assets into fewer, but larger, banking organizations.

Branch Banking The drive toward consolidation of banks into larger organizations is most evident in the long-term shift toward branch banking. Many of the nation’s largest banks have followed their customers to distant markets across the nation through branching and mergers, so as to protect their sources of funds and their earnings.

Bank Holding Companies Paralleling the rapid growth of branch banking has been the growth of bank holding companies – corporations organized to acquire and hold the stock of one or more banks. Holding companies have become the predominant bank organizational form because of their advantages in raising capital, spreading out their risk exposure, and allowing entry into new business opportunities.

Banks and Bank Holding Companies The Top Banks and Bank Holding Companies in the United States Measured by Asset Size (Ranked as of 12/31/03)

International Banking Bank expansion into international markets has taken place through a wide variety of organizational forms: representative offices branch offices acquisitions of existing overseas banks, that then become subsidiaries of the international bank joint ventures with foreign firms

International Banking Some of the Largest Banks Around the Globe Source: Board of Governors of the Federal Reserve System and various central banks

The Convergence Trend in Banking Another important structural change occurring in banking today is convergence – banking organizations are looking more and more like other financial-service providers, offering many of the same services as security firms, insurance companies, etc. Several banks in Canada, Great Britain, and Western Europe long ago took an additional step to become universal and merchant banks.

The Convergence Trend in Banking In 1999, with passage of the Gramm-Leach-Bliley Act, leading banks in the United States began to move toward universal banking more aggressively, establishing financial holding companies (FHCs) and combining banking, securities, insurance, and other affiliates under one corporate umbrella.

Bank Failures The rapid expansion of bank services has not protected some banks and banking systems from getting into serious trouble. Banks have failed due to excessive risk-taking, intensified competition, the volatility of economic and financial conditions, crime, etc.

Changing Technology Banking today is also passing through a technological revolution. Computer networks and high-speed information processing are transforming the industry, stressing convenience and speed in handling such routine transactions as making deposits, extending loans, and paying for purchases.

Changing Technology Among the most important pieces of technology in the industry are automated teller machines (ATMs), point-of-sale (POS) terminals, automated clearinghouses (ACHs), and Internet-banking. These recent technological changes have profound implications for bank costs, employment, and profitability.

Portfolio Characteristics of Commercial Banks Primary reserves (cash and due from banks) consist of cash and deposits held with other banks. These reserves are the banker’s first line of defense against withdrawals by depositors and customer demand for loans. Commercial banks hold securities acquired in the open market as a long-term investment and as a secondary reserve to help meet short-term cash needs.

Portfolio Characteristics of Commercial Banks Loans are among the highest yielding assets a bank can add to its portfolio, and they often provide the largest portion of traditional banks’ operating revenue. To carry out their extensive lending and investing operations, banks draw on a wide variety of fund sources. The bulk of commercial bank funds  about two-thirds of the total  comes from deposits.

Portfolio Characteristics of Commercial Banks Principal nondeposit sources of funds for banks today include purchases of reserves from other banks, security repurchase agreements, and the issuance of capital notes. Recently banks have turned to new nondeposit funds sources, including floating-rate CDs and notes sold in international markets, sales of loans, securitizations of selected assets, and standby credit guarantees.

Portfolio Characteristics of Commercial Banks Securitizations of Bank Loans to Raise Funds

Portfolio Characteristics of Commercial Banks Bank Standby Letters of Credit Issued on Behalf of Their Customers

Portfolio Characteristics of Commercial Banks Equity capital (or net worth) supplied by a bank’s stockholders provides only a minor portion (only about 9 percent, on average) of total funds for most banks today.

Portfolio Characteristics of Commercial Banks

Portfolio Characteristics of Commercial Banks … continued Portfolio Characteristics of Commercial Banks

Portfolio Characteristics of Commercial Banks The majority of bank revenues come from interest and fees on loans. Interest and dividends on investment security holdings are the second most important source of bank revenues. Interest on deposits and other borrowed funds is the principal expense item for many commercial banks, along with the salaries and wages of their employees.

Portfolio Characteristics of Commercial Banks Greater competition from bank and nonbank financial institutions has resulted in increases in the real cost of raising funds, and the expense of upgrading computers and automated equipment has placed an added drain on bank revenues. The interest margin measures how efficiently a bank is performing its function of borrowing and lending funds.

Portfolio Characteristics of Commercial Banks Of increasing importance is the noninterest margin, which is the difference between total noninterest income and noninterest expenses. This is because commercial banks are developing more and more new services that generate noninterest fees, such as security underwriting services. Moreover, banks may minimize their noninterest expenses, particularly employee costs, by substituting automated equipment for labor.

Portfolio Characteristics of Commercial Banks

Portfolio Characteristics of Commercial Banks … continued Portfolio Characteristics of Commercial Banks

Managing Commercial Bank Performance Today Bank assets, liabilities, revenues, and expenses can be managed through written loan policies the positioning of the bank's investment portfolio meeting the bank’s liquidity needs through asset conversion or liability management paying special attention to the largest depositors and to those customers with large outstanding credit lines.

Managing Commercial Bank Performance Today The performance of a bank is evaluated not only relative to its own goals but also relative to the performance of its competitors. Four dimensions of bank performance tend to be the most closely followed in the industry: The bank’s market value or stock price The bank’s rate of return or profitability ratios The bank’s risk exposure The bank’s operating efficiency

Managing Commercial Bank Performance Today Note that performance measurement should always take into account differences in bank size, location, and especially the product-line focus each bank adopts as its principal service mission.

Managing Commercial Bank Performance Today

Money Creation and Destruction by Banks Banks have the power to create money in the form of new checkable deposits, credit card lines, debit cards, and other immediately spendable funds. As a whole, the banking system can create a volume of money equal to a multiple of any excess reserves deposited with it simply by making loans and purchasing securities.

Reserve Requirements and Excess Reserves Vault cash and deposits at the Fed constitute a bank’s holdings of legal reserves – those assets acceptable for meeting legal reserve requirements behind the public’s deposits. Each bank’s legal reserves may be divided into two categories: required reserves and excess reserves.

The Creation of Money and Credit The distinction between excess and required reserves is important because it plays a key role in the growth of credit in the economy and the creation of money by the banking system. By making loans whenever excess reserves appear, the banking system eventually creates total deposits and total loans several times larger than the original volume of new funds received.

The Creation of Money and Credit

The Creation of Money and Credit

Destruction of Deposits and Reserves Similarly, the money supply can contract by a multiple amount when legal reserves are withdrawn from the banking system.

Destruction of Deposits and Reserves

Destruction of Deposits and Reserves

Implications of Money Creation and Destruction Creation of money by banks is one of the most important sources of credit funds in the global economy. However, money created by banks is instantly available for spending, and therefore, unless carefully controlled by government action, the creation of money can fuel inflation.

Markets on the Net American Bankers Association Career Website at www.aba.careersite.com Board of Governors of the Federal Reserve System at www.federalreserve.gov Federal Deposit Insurance Corporation at www.fdic.gov Federal Financial Institutions Examination Council at www.ffiec.gov

Markets on the Net Financial Reports for Individual Banks at www.fdic.gov/bank/individual FYI and Bank Trends Publications at www.fdic.gov/bank/analytical/fyi Office of the Comptroller of the Currency at www.occ.treas.gov

Chapter Review Introduction to Banking The Structure of U.S. Commercial Banking A Trend Toward Consolidation Branch Banking Bank Holding Companies International Banking The Convergence Trend in Banking Bank Failures Changing Technology

Chapter Review Portfolio Characteristics of Commercial Banks Cash and Due from Banks (Primary Reserves) Investment Security Holdings and Secondary Reserves Loans Deposits Nondeposit Sources of Funds Equity Capital Revenues and Expenses

Chapter Review Managing Commercial Bank Performance Managing Bank Assets, Liabilities, Revenue and Expenses Monitoring the Performance of a Bank Money Creation and Destruction by Banks and Bank Accounting The Creation of Money and Credit Destruction of Deposits and Reserves Implications of Money Creation and Destruction