Chapter 14 The Commercial Banking Industry: Structure, Products, & Management McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

 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. 14-3

Introduction  The dominant privately owned financial institution 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. 14-4

The Structure of U.S. Commercial Banking  Banking structure  The number of commercial banks  The sizes of commercial banks  In most other nations the banking system consist of a few large banking organizations  The U.S. system is numerically dominated by thousands of small banks  However they tend to be smaller than banks in other nations  But most assets are concentrated in a small handful of banks 14-5

The Structure of U.S. Commercial Banking Number of Operating Insured Commercial Banks and Branch Offices in the U.S., Year-end 2005 Source: Board of Governors of the Federal Reserve System Annual Report

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 larger banking organizations 14-7

A Trend Toward Consolidation  Pressures are operating to form larger banking organizations  More efficient use of resources  The number of banks have fallen from about 14,000 to less than 7500  Average U.S. bank is larger than in the past  Largest U.S. banks gaining market shares  At the expense of small and medium banks  Largest saw market share go from 40% to 76%  Also average profitability higher 14-8

A Trend Toward Consolidation  Consolidation continues  Evidence the trend is slowing in the U.S.  It appears that mergers are being balanced out by the creation of new banks  The industry might be forming a divided organizational structure  Small number of global money-center banks  Community banks serving cities and suburbs 14-9

A Trend Toward Consolidation  Research suggests that banks have economies of scale  As a firm grows, costs grow slower than output  Results in cost savings  Under economies of scale, larger banks are more competitive  Benefits are limited  Level off at about $1 billion in assets  Larger banks tend to offer more services and bear more costs 14-10

Branch Banking  Consolidation of banks into larger organizations  Most evident in the long-term shift toward branch banking  Many of the nation’s largest banks have followed their customers to distant markets  Branching  Mergers  Protect their sources of funds and their earnings 14-11

Bank Holding Companies  Growth of bank holding companies  Corporations organized to acquire and hold the stock of one or more banks  Parallel trend to branching  Holding companies have become the predominant bank organizational form  Advantages in raising capital  Advantages in spreading out their risk exposure  Advantages in entry into new business opportunities 14-12

Banks and Bank Holding Companies Leading Bank Holding Companies Registered in the United States and Measured by Asset Size in $ Billions (Ranked as of March 31, 2005) 14-13

Financial Holding Companies  A new type of financial-services holding company (FHC)  Created in 1999  From Gramm-Leach-Bliley  Bring together various financial institutions under the same holding company  Approaching structure of leading European banks  Currently over 500 FHC with more than 90% of the total assets of the U.S. banking industry 14-14

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 14-15

International Banking Some of the Largest Banks Around the Globe Source: Board of Governors of the Federal Reserve System and various central banks 14-16

The Convergence Trend in Banking  Convergence in banking  Banking organizations are looking more and more like other financial-service providers  Banks are offering many of the same services as security firms, insurance companies, etc.  Several banks in Canada, Great Britain, and Western Europe long ago became universal and merchant banks 14-17

Bank Failures  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  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  Making deposits  Extending loans  Paying for purchases 14-19

Changing Technology  Among the most important pieces of technology  Automated teller machines (ATMs)  Point-of-sale (POS) terminals  Automated clearinghouses (ACHs)  Internet-banking  Recent changes have profound implications  Bank costs  Employment  Profitability 14-20

Changing Technology  One problem for online transactions  Increasing incidence of identity theft  At least 5% of internet users claim to have given up online banking recently due to security problems  New regulations  Effective in the U.S. in December 31, 2006  Requires more sophisticated account- access procedures 14-21

Portfolio Characteristics of Commercial Banks  Primary reserves  Consist of cash and deposits held with other banks  Reserves are the banker’s first line of defense  Against withdrawals by depositors  Against customer demand for loans  Commercial banks hold securities acquired in the open market  Long-term investment  A secondary reserve to help meet short-term cash needs 14-22

Portfolio Characteristics of Commercial Banks  Loans are important to banks  Among the highest yielding assets a bank can add to its portfolio  Provide the largest portion of traditional banks’ operating revenue  Banks need funding to carry out lending and investing operations  Draw on a wide variety of fund sources  About two-thirds comes from deposits 14-23

Portfolio Characteristics of Commercial Banks  Monies set aside in case a loan defaults is referred to as a loan loss allowance  It is the difference between gross and net loans  Annual contributions to the loan loss reserve is referred to as the provision for loan losses 14-24

Portfolio Characteristics of Commercial Banks  Three types of deposits  Demand deposits (checking accounts)  Important for transactions  Safer than cash  Savings  Low interest rates  Low dollar amounts  Time deposits  Fixed maturity  Highest rate of return offered 14-25

Portfolio Characteristics of Commercial Banks  Principal nondeposit sources of funds  Purchases of reserves from other banks  Security repurchase agreements  Issuance of capital notes  Recently banks have turned to new nondeposit funds sources  Floating-rate CDs and notes sold in international markets  Sales of loans  Securitization of selected assets  Standby credit guarantees 14-26

Portfolio Characteristics of Commercial Banks Securitizations of Bank Loans to Raise Funds 14-27

Portfolio Characteristics of Commercial Banks Bank Standby Letters of Credit Issued on Behalf of Their Customers 14-28

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  Critical funding to the bank  Helps keep a bank open in the face of operating losses  Minimal capital requirements 14-29

Portfolio Characteristics of Commercial Banks  Revenues  Interest and fees on loans  Interest and dividends on investment security holdings  Expenses  Interest on deposits and other borrowed funds is the principal expense item for many commercial banks  The salaries and wages of their employees are also a major expense 14-30

Portfolio Characteristics of Commercial Banks  Bank’s expenses have been rising  Greater competition from bank and nonbank financial institutions  Increases in the real cost of raising funds  Expense of upgrading computers and automated equipment  Lowering interest margin  The interest margin  Net interest income less total interest paid  Measures how efficiency bank is performing 14-33

Portfolio Characteristics of Commercial Banks  Recently interest expenses have been dropping  Lower average market interest rates  Major banks have been shifting more activities off the balance sheet  Larger banks are evolving from traditional structures into complex banking companies 14-34

Portfolio Characteristics of Commercial Banks  Also important is noninterest margin  Difference between total noninterest income and noninterest expenses  Commercial banks are developing more and more new services  Generate noninterest fees  Moreover, banks may minimize their noninterest expenses,  Particularly employee costs  Substituting automated equipment for labor 14-35

Portfolio Characteristics of Commercial Banks 14-36

Portfolio Characteristics of Commercial Banks 14-37

Managing Commercial Bank Performance Today  Bank assets, liabilities, revenues, and expenses can be managed  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 14-38

Managing Commercial Bank Performance Today  Recent research  Sources of liquid funds banks borrow daily  Proliferating rapidly  New challenges for bank management  Bankers rely less on traditional deposits  More dependent on innovative sources of liquidity  Interest sensitive 14-39

Managing Commercial Bank Performance Today  The performance of a bank  Evaluated relative to its own goals  Also evaluated relative to the performance of its competitors  Four dimensions of bank performance tend to be the most closely followed  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 14-40

Managing Commercial Bank Performance Today  Note that performance measurement should always take into account various differences  Bank size  Location  Especially the product-line focus each bank adopts as its principal service mission  Another important dimension of bank performance is efficiency 14-41

Money Creation and Destruction by Banks and Bank Accounting  Banks have the power to create money  Form of new checkable deposits  Credit card lines,  Debit cards  Other immediately spendable funds  The banking system can create a volume of money  Equal to a multiple of any excess reserves deposited  Simply by making loans and purchasing securities 14-42

Money Creation and Destruction by Banks and Bank Accounting 14-43

Money Creation and Destruction by Banks and Bank Accounting  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 14-44

Money Creation and Destruction by Banks and Bank Accounting 14-45

Money Creation and Destruction by Banks and Bank Accounting 14-46

Money Creation and Destruction by Banks and Bank Accounting  Similarly, the money supply can contract by a multiple amount when legal reserves are withdrawn from the banking system 14-47

Money Creation and Destruction by Banks and Bank Accounting 14-48

Destruction of Deposits and Reserves 14-49

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  Money created by banks is instantly available for spending  Need for monitoring by government  Creation of money can fuel inflation 14-50

Markets on the Net  ABN AMRO at  American Bankers Association Career Website at and aba.careersite.com aba.careersite.comwww.aba.com aba.careersite.com  Bank of China Ltd. at  Bank Systems and Technology at banktech.com banktech.com  Bankrate.com at bankrate.com bankrate.com  Barclays at barclays.co.uk barclays.co.uk 14-51

Markets on the Net  Board of Governors of the Federal Reserve System at  CapitalOne at capitalone.com capitalone.com  China Construction Bank at  Citibank at  Consumer Action at action.org action.orgwww.consumer- action.org 14-52

Markets on the Net  Federal Deposit Insurance Corporation at  Federal Financial Institutions Examination Council at  Federal Reserve Bank of Chicago at chicagofed.org chicagofed.org  Financial Reports for Individual Banks at  FYI and Bank Trends Publications at

Markets on the Net  IDC Financial Publishing at  Industrial and Commercial Bank of China at  ING Direct at home.ingdirect.com home.ingdirect.com  JPMorganChase at  Keybank at  Metlife Bank at metlifebank.com metlifebank.com 14-54

Markets on the Net  Office of the Comptroller of the Currency at  Sheshunoff at sheshunoff.com sheshunoff.com  Societe Generale at socgen.com socgen.com  Unicredit Group at  Veribank Riskwatch at  Wells Fargo Bank at

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 14-56

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 14-57

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 14-58